The current bull market will live or die in the first quarter of this year, with warning signals still flashing despite a promising start, Jeff Schulze, investment strategist at ClearBridge Investments, a Legg Mason affiliate, has said.
While the US has set fresh record highs so far this year, Schulze said investors should be careful not to get caught out by becoming complacent about the outcome.
A particular point to focus on is the current round of rate cuts from the Fed. While these can – and have – led to soft landings in previous cycles, they have also led to recessions, and while aggressive price action from the Fed has been greeted with cheer on Wall Street so far, he said there remained a risk that the economy, and markets, could still tank.
“The stock market has a poor track record of identifying recessions early,” he said. “A deeper examination of recent periods where the Fed has provided three rate cuts shows mixed results: two recessions and two soft landings.
“Importantly, the market’s initial reaction in the first three months was not helpful in identifying which scenario played out as the market moved higher most of the time.”
Schulze said in previous cycles, the key signal on the economy actually came six months after the third rate cut, with negative price action signifying recession and positive price action signifying soft landing. Translating that into the scenario currently facing the Fed, the third rate cut occurred on October 30th 2019, making the end of the first quarter a critical juncture.
Schulze added that while the yield curve is no longer inverted, this may be falsely interpreted by watchers as an ‘all-clear’ signal for markets. When the yield curve inverted previously, investors grew concerned that it was the harbringer of a recession, and Schulze said it would be wrong to dismiss this just because the curve has un-inverted.
“Many participants believe that the un-inversion of the yield curve means a recession has been averted. History, on the other hand, would suggest that this scenario is not a bullish sign for the economy. In fact, the yield curve was in positive territory ahead of each of the past three recessions, with an average steepness of 67 basis points at the onset of the recession,” he said.
“Further, the last three inversions occurred between eight and 16 months before the recession hit, and we are just six months past the initial inversion of the yield curve at present. This means we may not be out of the woods quite yet.”
He added the trajectory for the current rally very closely echoed previous periods which led to recessions.
“The current market rally is consistent with history, as the S&P 500 rose by double digits for over a year following the 1989 and 2006 yield curve inversions, both of which ended in a recession,” he said.
Although the yield curve may not be the most accurate guidepost in the near term, Schulze said a closer examination into business and consumer confidence should provide some important clues. Business confidence appears to have stabilised recently while consumer confidence continues to flirt with cycle highs.
“While we don’t believe that business confidence and capex can bounce materially because of margin pressures, it could be enough to encourage businesses to keep their headcounts steady as we move through a soft patch in the economy. Layoffs are traditionally the last domino to drop as recessions unfold,” Schulze said.
“If a soft landing (and not a recession) is the ultimate destination, it will likely look much different than the sharp recovery of 2016/2017. First, there’s less spare capacity in most major economies today with unemployment rates at or near multi-decade lows. This acts as a governor on how fast the economy can ultimately grow.”