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Are We Headed For a Recession? Positioning Portfolios for 2020 and Beyond

Are We Headed For a Recession? Positioning Portfolios for 2020 and Beyond

December 27, 2019
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It's a new decade, and with that comes the obscure vision of the years to come. Many investors are skittish heading into an election year due to political uncertainty; however those with long-term investment time horizons should not need to deviate from their established plans. While we don't know exactly how the markets will behave in 2020, we have some ideas to help you construct the strategic portion of your investment portfolios given the current economic environment. 

Current market environment

As you know 2020 is an election year, and with elections comes volatility and uncertainty. Many investors worry about the outcome of an election and which political party sits in the oval office. The truth is that presidents have had very little effect on long-term market conditions, other than significant tax law changes. It may seem that they have significant influence due to the short-term market volatility that presents itself, but that volatility is actually due to investors' short-term emotional responses to news, and policy change. Broader market and economic fundamentals have historically come back into play eventually.

On the economic front, the United States currently resides in an easy monetary policy environment. What does that mean? It means that money is cheap. Interest rates are low and are extremely likely to remain low, maybe even decline further (although the Fed has mentioned they are done cutting). The Fed lowered rates multiple times throughout 2018-2019 and did so because inflation (the rate at which prices increase in the U.S.) had not been rising to their expectations. If inflation does increase near their target, it will also have to sustain that target for a meaningful period of time, not just reach it. Inflation is currently not close to the Fed's target of 2%, it is hovering around 1.7%.

There is no guarantee that if-and-when the previously mentioned Fed inflation target is hit, that they will increase interest rates immediately. The average reading of inflation that has caused the Fed to actually hike rates has historically been well above a sustained 2%. We would have to see a significant change in the economy to see these ranges of inflation, which won't happen overnight. This is why we think low rates are here to stay, at least through 2020. Low rates help spur the U.S. economy by giving people access to cheap money. They then purchase big ticket assets like automobiles and houses, further bolstering the economy.

One if not the most powerful drivers of the current stock market and economy has been you, the consumer. Starting in 2019, there has been a lot of worry about trade tensions, primarily with China. However, consumer strength and spending in the U.S. has not actually reflected any negative ramifications. In other words, certain corporations may be feeling the hurt but the end U.S. consumer hasn't even noticed. In fact, we are stronger than we've been in quite a while. Know any business owners? Ask them how their business is going; more often than not you are going to hear that they are having record years and are continuing to grow. As long as monetary policy stays relatively muted, and the consumer stays strong, we believe we should have a successful, yet volatile 2020.

Are we heading into a recession soon?

Let me start by saying: bull markets (up-trending markets) do not die of old age! Based on the current economic conditions we do not believe a recession is coming in 2020, nor 2021 (even though we are currently in the longest bull market in history). We do feel that there may be one or multiple market pullbacks/corrections over the next two years. It would be wise to leave room for knee-jerk reactions from investors due to the coming election, media, corporate earnings seasons, and further comments from the Fed. Another reason we may see some market pullbacks is due to stock valuations. Nearly everything is relatively "expensive" in the current market, even bonds. When stocks have very high valuations; investors tend to sell off stock holdings because they believe the stock is "too hot" or the "price-to-earnings" ratio is rising too quickly.

We however do not see this as a major issue to worry about; the reason is that there are a lot of relatively "expensive" or high "P/E ratio" stocks that are actually growing their top lines. In layman's terms, these companies are consistently making more money, therefore their price warrants a high P/E ratio. This is opposed to the "dot com" bubble in the early 2000s, when we saw a major market correction due to extremely high stock valuations. The difference being that the internet stocks at that time didn't have the earnings to support those high valuations, creating a bubble ready to burst.

Recessions are caused by "excesses" that are built up somewhere in the economy. Ultimately, they are actually caused by some sort of "catalyst" or "trigger" that exposes the excess. Currently we do not see excesses in any sectors of the economy, although we have noticed that corporate debt has started to climb significantly. Part of the reason behind this are the tax incentives that were given to corporations in the "Tax Cuts and Jobs Act of 2017", and the previously mentioned easy money policies. This may become an issue down the road if it continues to escalate and some sort of catalyst is brought into the equation. An example of a possible catalyst in our current market could be: tighter monetary policy - i.e. a reversal in interest rates (rates rise, and too quickly).

If the corporate debt levels do create a bigger problem and contribute to some sort of recession, we feel that it will not be of the size and magnitude of the "Great Recession" in 2008. The reason for this is that recessions that stem from the corporate sector (i.e. internet bubble) are typically less severe. They do not have the "branches" so to say, to drag down other sectors of the economy. Compare this to a recession that stems from banking and housing (i.e. Great Recession); these are sectors that affect nearly every consumer in the U.S.. The corporate debt is held for the most part, outside of the banking sector. We believe the largest threat to the economy at this point would be an aggressive Fed in terms of raising interest rates, which we also feel is extremely unlikely.

One other important note is that if there is a bear market or recession in the near future, we don't feel it would last long. This is because interest rates are so low that it would be too hard for retirees to find the returns and income they need. Therefore, they would likely have to turn to stocks that pay high dividends or invest in companies that are growing their profit margins, therefore raising their stock price (appreciation).

Adjusting portfolios for 2020 and beyond

Investors may want to consider making slight portfolio adjustments to help smooth volatility in 2020. That does not mean their overall portfolio objective should change - meaning they likely shouldn't make any major tilts towards equities (stocks), or away from fixed-income (bonds), or vice versa. We would suggest that investors keep core holdings based on their long-term goals and risk tolerance, rebalance annually, and make adjustments as needed within the asset classes they already hold.

For example: if you currently have a portfolio or retirement account with 70% in stocks, you'd want to consider making sure that a decent portion of those stocks are companies whose top lines will still be able to grow in a volatile environment, and pay a dividend. If you have access to stocks that have a history of increasing their dividends (even in difficult times), it could be wise to add those as well, keeping in mind that past performance does not guarantee future results. Dividends and/or income can help smooth portfolio volatility that comes from your riskier equity investments.

Because interest rates are so low given current conditions, some investors and retirees may be finding it hard to generate enough income (aka yield) from bonds. The amount of income that corporate bonds currently pay (their yield) is not much more than U.S. treasury yields - which are considered virtually risk-free investments by the markets. This means that you take additional risk investing in corporate bonds for income, vs. getting almost the same amount of income from an asset with less risk such as U.S. treasuries. So how can we potentially enhance the amount of income our portfolio provides given these conditions? Like we mentioned previously, investors may want to consider stocks that pay high dividends, or have a history of increasing them consistently.

For those with fixed-income investments (bonds) in their portfolio allocation; we are currently using them primarily to help offset the volatility that may come from equities. This is opposed to owning them purely for their income payments. As far as the type of bonds, we believe investors should consider allocating more towards treasuries and mortgages. In other words, increase the quality of the fixed-income holdings that may already be held.

The bottom line

Having a living financial plan is key to understanding how you are going to pursue your goals while investing. Having a good financial planner is key to making sure you don't veer off the path when uncertainty arises. Stay invested based on your long-term plan and make slight adjustments along the way to fit your needs. Be careful not to limit your mindset to only stock market investments. We believe a good financial planner should be helping you first and foremost to understand your overall capital (all assets), and how you are going to manage it to pursue your goals

Please send Cameron your questions and feedback via our website.

    

Cameron Valadez is a CFP® Practitioner.


 

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. It is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.

All investing, including stocks, involves risk and the potential to lose principal, and there can be no guarantee that any investing strategy will be successful. Generally, the greater the risk, the greater the potential reward. You should determine your risk tolerance and financial goals before deciding to invest.  Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Keep in mind that rebalancing may have tax consequences and transaction costs. Please consult with your tax advisor regarding your personal situation.