In brief
- U.S. economic recessions were typically driven by cutback in corporate spending
- We are monitoring corporate sentiment and companies’ ability to borrow and service debt as a potential trigger for an economic downturn
- As the U.S. economy transition towards later part of the economic cycle, investors should look for a more balanced allocation between equities and fixed income
Understanding the anatomy of recessions
While investors will inevitably be focusing on the Federal Reserve’s policy this week, one question on the back of everyone’s mind would be the risk of a recession in the U.S. This is relevant since most risk assets perform poorly during recessions and investors need to take a much more defensive approach in asset allocation. In this article, we discuss the drivers of recessions and what current economic data is telling us.
Let’s start by looking back at previous recessions (Exhibit 1) and there are several observations. First, the last two recessions, the global financial crisis and the COVID-19 pandemic, were particularly severe. Even though we cannot accurately predict the trigger of the next downturn, a more conventional recession should be less painful for households and companies.
Second, most recessions have seen private investment contract more than personal consumption, especially in inventory correction. Hence, it is important to consider corporate sentiment in capital spending and hiring. In fact, personal consumption managed to expand in two of the last five recessions. This also explains why companies in the consumer staple and utilities sectors are more resilient since consumers cannot cut back on necessities.
Not surprisingly, government spending provided some positive contribution to offset the economic contraction. Part of this is via reduced tax revenue and an increase in social security payments and unemployment benefits, commonly known as automatic stabilizers. The U.S. Congress may also pass economic stimulus bills to support the economy, depending on the political landscape at the time.
Exhibit 1: U.S. economic recessions and contributors to GDP
Source: BEA, NBER, J.P. Morgan Asset Management. Non-residential, residential and inventories are sub-components of private fixed investment. Values reflect average quarterly GDP growth during recessions. Peak-to-trough dates reflect NBER classification of recessions.
Data are as of June 10, 2022.
What are some of the potential weak spots in the economy?
There are several areas where the U.S. economy is showing signs of overheating. Unemployment rate is at a multi-decade low, leading to strong wage growth. By itself, it can be argued that a vibrant job market supports consumption, especially when the cost of living is rising rapidly. However, this could also pressure the Fed to raise interest rates more aggressively to cool down the economy.
Back to the corporate sector, corporate sentiment is obviously an important gauge and we have seen some cooling on the ISM manufacturing new orders, indicating some slowdown in corporate spending. While corporate leverage (debt-to-GDP) level is high, this vulnerability is partly offset by strong cash position, implying a more resilient net debt position.
Moreover, the debt service burden for companies is still manageable. We will continue to monitor whether tighter monetary policy, from both higher policy rates and quantitative tightening, would push borrowing costs higher, reduce appetite to lend and force companies to cut back on spending.
Investment implications
Overall, there are some signals that the U.S. economy is moderating with more cautious corporate sentiment and investment, as well as inventory destocking. While consumers are facing a higher cost of living, their fundamentals are still resilient, especially the robust job market and rising wages.
As the U.S. economy is in the process of transition from the mid-part of the growth cycle to late cycle, investors can adopt a more balanced allocation between equities and fixed income. The painful adjustment since the start of year probably have partly factored in economic slowdown. We also expect quality companies with a strong balance sheet and pricing power will be able to withstand rising costs and higher rates. This quality bias would apply to both equities and corporate credit. It should be noted that risk assets can still deliver positive return in the late phase of the economic cycle.
The surge in U.S. Treasury yields in the past year means government bonds can once again play an important role in portfolio construction. With its low yield and rising inflation in the past 12 months, it was ineffective in hedging against risk assets, especially equities, volatility. The strong May inflation print has lifted bond yields again, but the current yield level should start to look attractive to investors looking for a low volatility to generate income.
09yg221406031435