Dear Clients and Friends,
I figured it was a good time to write everyone today as a result of the large preponderance of the word “Recession” in the media the past few days and in conjunction with this recent equity market volatility.
The main question that I’ve been getting this week is, “Are we going to have a recession, and if so when is it coming?” At this point I go into a long drawn out response that could be easily summed up with, “I don’t know.” The next question that comes after this exchange is, “What are we doing to prepare if we have a recession?” This question, I do have an answer to.
To address the first question, I can tell you all that we have many good things going for our economy and few bad things. The negative factors do include several of the other larger economies around the world having slowing GDP which could eventually impress upon the US economy. Add in an inverted yield curve and the trade war uncertainty and you have a recipe for the media to start talking recession. Below is a non-exhaustive list of Pro’s and Con’s of the global economy.
- The world economy is still GROWING, just at a slower pace than in 2018
- Household debt levels are not too high
- Oil prices are down which gives consumers more money to spend
- The average months from a yield curve inversion to a recession is approximately 22 months
- German Government Bonds are negative out to 30 years maturity (deflationary)
- Swiss Government Bonds are negative out to 50 years maturity (deflationary)
- US Yield Curve is inverted
- US Interest Rates are already low which gives the Fed less room to lower if we go into recession
- China economy hasn’t been this slow since 2002
- US/China Trade War Uncertainty
In particular, the big talk this week in relation to a possible recession is the inverting of the US Treasury yield curve. An inverted yield curve has historically been a fairly accurate indicator for an upcoming recession. However, if you look at the past inversions, and the corresponding entry into a recession (and eventual equity market retraction), we average approximately 22 months before that happens. So, based on this evidence, we can assume that even if we do enter a recession, we should still have some equity market upside before we actually experience a market decline. That is, if history repeats itself like it has the past several inversions.
Now for answering the second question; “What are we doing about it?” Well, we started adding a structured note to most of our portfolios back in May and June to give us a limited downside if we have a market decline but still allow us to participate in the markets if they were to move up. There were two notes that we had designed for us, one is by Goldman Sachs and the other is by Morgan Stanley. Most clients ended up with approximately 10 to 15% in one of the positions. The note details are below. Also, for many of the portfolios we got rid of a more aggressive fixed income position and went back to a more traditional high-quality bond fund that should hopefully act as a buffer to stock market declines.
- GS Note = S&P 500 Index & DOW Jones Industrial Average
- 10% buffer
- 19% Cap return
- 18-month maturity (matures on Nov. 20th, 2020)
- MS Note = Global Basket on SPX, SX5E, NKY
- 20% Buffer
- 13.1% CAP return
- 120% leverage on the upside
- 19-month maturity (matures on 12/24/2020)
Lastly, to address the more recent volatility of last week and this week. Most of this volatility is not bad relative to the volatility we’ve experienced over the past two years. You can see on the chart below that it is only about one-third the decline on the S&P 500 as compared to what we experienced from October 3rd to December 26th of last year. It’s my opinion that the recession rhetoric along with this price movement exacerbated a lot of investors emotions and made them feel like it is worse than it actually was. Although we’ve had some bumpy roads the past two years, we still are up approximately 15% on the S&P 500. This is a good lesson to not let emotion take over when investing.
To sum everything up, I can’t tell you if we’re going to have a recession, and if we have one, when it will come, but I am staying on top of the risk management for our portfolios. For right now, there doesn’t seem to be a reason to worry much.
As always, please feel free to call or email me if you have any questions.