One recession indicator that tends to be reliable is the shape of the yield curve, since recessions typically follow about nine months after the yield curve inverts. The yield curve remains positive but flattening. It is likely to invert sooner rather than later as long as the Fed continues raising rates.
We don’t see signs of an imminent recession, but late cycle pressures appear to be building. We’re hearing anecdotal stories about labor shortages and supply bottlenecks from corporate management teams. And wage growth is slowly climbing and could accelerate. The Labor Department’s employment cost index rose 2.8 percent in the second quarter, the fastest pace in a decade. We expect inflation will continue to slowly rise (and perhaps accelerate slightly), which will put additional pressure on the Fed to raise interest rates.
Risk 2: Trade Tensions Remain A Serious Economic And Market Threat
Tariffs are taxes. They result in greater inefficiencies between the producers of goods and prospective consumers, and can potentially act as a broader drag on global economic growth. Perhaps more importantly from an equity investing perspective, current trade uncertainty is complicating forward planning for corporate management teams and causing some to delay capital spending plans.
President Trump believes the current U.S. trade deficit is caused by unfair trade practices. It may be true that countries like China play by different rules when it comes to issues like copyright protection, but trade balances mainly reflect relative economic growth and exchange rates. The great irony when it comes to the president’s trade policies is that actions such as tax cuts and efforts to boost private investment spending are more likely to boost the trade deficit since they put upward pressure on the U.S. dollar. This is no doubt why President Trump has been railing against higher interest rates. In any case, increasing tariffs won’t change the underlying dynamics of the U.S. trade deficit. And more to the point, we don’t expect trade issues to be resolved any time soon.
Risk 3: Earnings Expectations May Be Too High
Corporate earnings and profit margins have been exceptionally strong in the first half of the year. And analysts remain very bullish about prospects for future earnings. At present, consensus expectations are for S&P 500 earnings to rise 14 percent over the next 12 months and long-term earnings to increase by 16 percent per year.2 That growth level was only exceeded during the 1990s tech bubble, and we think it seems extremely high.2
As interest rates and wage pressures rise, we think earnings growth is bound to slow. The benefits of the 2018 tax cuts will fade over time, while borrowing and labor costs are rising. A slowdown in earnings (and/ or earnings results disappointments) could remove a major tailwind for equity prices.
Equity Prices Should Keep Rising For Now, But Increasing Caution Is Warranted
There may be a “perfect” time to invest in equities: when markets are cheap, earnings expectations are overly pessimistic and monetary policy is highly accommodative. In fact, that pretty well describes 2009. The environment looks quite different today. Valuations may be somewhat stretched, earnings expectations are highly optimistic and the Fed is tightening.