Why Are Some Investors Turning Defensive During a Market Rally? | Lord Abbett
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Economic Insights

Even amid the current strength in risk assets, asset prices appear to be influenced more by fears of a U.S. recession than they usually are. We think it’s too early to be overly defensive.

What typically happens before U.S. economic growth turns negative? Well, the U.S. index of leading economic indicators (LEI) has peaked and turned down noticeably well before the beginning of every U.S. recession since the late 1950s. It has also leveled off during periods when economic growth has slowed (1995, 1998, 2002-2003, 2012, 2014-2015, today) without turning down sharply enough to signal that the probability of a recession beginning soon was increasing significantly. And after each of those episodes, economic growth reaccelerated.


Chart 1. What Might U.S. Leading Indicators Be Signaling about the Economy?
U.S. Index of Leading Economic Indicators, January 31, 1959­–December 31, 2019

Source: U.S. Federal Reserve Bank of St. Louis.  Data as of February 11, 2020. The Composite Index of Leading Indicators is used to predict the direction of global economic movements in future months. The monthly index is composed of 10 economic components whose changes tend to precede changes in the overall economy. 


How reliable is the LEI as a recession signal? Unfortunately, the variables and weightings that go into the index—and the ones left out—have changed over time in order to  produce the “best” estimate of major turning points that can be constructed with the knowledge we have now but did not have in the past. This makes the indicator vulnerable to “over-fitting,” as the index constructors strive to fine-tune the LEI, and guarantees that it will not perform as well in the future as it has in the past.

Leading indicators can miss key turning points if a recession is the result of a very strong negative shock that cannot be anticipated (like the one induced by the global financial crisis in 2008–09).  Conversely, they may indicate that a sharp lurch downwards is approaching if formerly reliable indicators, such as the slope of the yield curve, deliver an inaccurate signal for an unprecedented reason. (We have previously discussed why a sharply negative term premium may diminish the effectiveness of the yield curve as a recession predictor.) The upshot is that while the LEI currently implies that a recession isn’t likely to develop anytime soon, we shouldn’t assign that outcome a probability of zero.

In contrast to the leading economic indicators, the chance of a recession starting in the next 12 months is estimated to be higher than usual based on most statistical models; an indicator from Bloomberg Economics puts the current odds at around 28% versus a historical median of 14%. The estimates are likely elevated due to the weights assigned to the slope of the yield curve and real economy data from the manufacturing sector.  Those weightings may have less relevance today due to the previously discussed negative term premium (in the case of the yield curve) and the diminished role of manufacturing in overall U.S. economic output.


Chart 2. A Widely Followed Recession Predictor Has Crept Higher in the Past Few Mnnths
Estimated probability of a U.S. recession in the following 12 months, February 28, 1990–December 31, 2019

Source: Bloomberg Economics. Data as of February 11, 2020. Bloomberg Economics’ U.S. recession probability indicator shows the chance of a downturn within the next 12 months. The model uses a range of financial market, real economy, and economic imbalance indicators to gauge the 12-month risk of recession.


In combination with the fact that the current U.S. economic expansion – 127 months and counting – is the longest ever, elevated statistical recession probabilities factor into the expectations of investors along with the neutral signal from the leading indicators. Thus, notwithstanding the recent rally, it is likely that asset prices are currently influenced more by fears of a downturn than they usually are.

While much higher-than-average U.S. equity forward earnings multiples and narrower-than-average credit spreads imply that investors are incorporating a rosy economic outlook into their decisions, very low bond yields and expectations that short-term interest rates will fall, along with sub-2% long-term inflation breakevens,1 suggest the opposite. The upshot is that if a recession is avoided, or if the chances of a downturn recede, asset prices should continue rising and outperform risk free rates.

Inasmuch as low inflation, restrained capital spending by businesses, strong residential construction, and modest inventory accumulation all imply that there are no major imbalances in the real economy and financial conditions are very permissive, maintaining or overweighting exposure to risk assets is still justified, in our view. We believe it is too early to turn defensive.


1Refers to the breakeven inflation rate, which represents a measure of expected inflation derived from 10-Year U.S. Treasury Constant Maturity Securities and 10-Year U.S. Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 10 years, on average.

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