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Monthly Perspective | June 2019

13 June 2019

Clint McGarvin, CFA® | Portfolio Manager/Research Analyst

What Defines a Recession and
What Are Some Causes?

May was a difficult month for equity markets, as stocks around the globe slid close to 6%. This poor showing, combined with the difficult year for investors last year and an inverted yield curve, now has industry commentators mentioning the dreaded R-word again. The word “recession” makes for a powerful headline, and the topic has been popping up more and more these days.

Following a recession, the average time it takes for the economy to reach the previous peak in economic activity is approximately 11 months. A recession is a scary concept for anybody, but especially for those to whom it might mean losing a job. Politicians hate recessions while they are in office, but they really hate them when one occurs close to re-election time.

June marks the 10-year anniversary of the end of the most recent recession and the beginning of the current expansion, making the current 120 months run the longest expansion in U.S. history. We are now in uncharted economic waters. It makes sense, then, to more closely examine and try to understand what a recession is and what are some causes for recessions.  It also helps to look at some excellent indicators of recessions and see where they are currently pointing.

The National Bureau of Economic Research defines a recession as a “significant decline in economic activity lasting more than a few months.” This part of the definition is typically interpreted to mean that the decline in economic activity lasts for at least two successive quarters. However, this definition does not match several recessions. For example, the graph below shows how, in the recession in 2001, the GDP was negative before the NBER called a recession – but then the GDP turned positive and then negative again. What’s noteworthy is that each move occurred within one quarter. The 2001 recession never had two successive quarters of negative GDP growth.

The recession in 1960-61 followed the same pattern. Therefore, the NBER uses other factors, too, when defining a recession: employment, industrial production, the volume of sales in manufacturing and wholesale-retail sales, and real income. Much like GDP, the NBER has called a recession even when one of these other metrics have still been expanding. This is one of the reasons why predicting the next recession is so difficult.

The catalyst for a recession may be different from the preceding recessions, but they all have the same basic cause: a build-up of imbalances within the economy which must be corrected. In 2001, the imbalance was a bubble in the stock market. Technology stocks soared to unsustainable heights and the catalyst was the inevitable decline in stock prices, which resulted in lower consumer and business spending. The most recent recession got started as the debt in the housing market increased to unsustainable levels. Home buyers were taking out mortgages they could not cope with, which increased defaults and created a volatile housing market, which then, in turn, bled into business and consumer spending and lead to significant losses in banking. In the late 1980s, Japan was hit by a bubble in both equity and real estate prices, and when the bubble popped, it sent Japan into an economic malaise that has persisted since 1989.

The data points that would indicate a recession feed into the economic series used by the NBER. Its parameters used to determine a recession include the Treasury Yield Curve, corporate profits, the Leading Economic Index, unemployment, durable goods orders, and stock market prices. The chart below shows the difference between the 10-year Treasury and the 3-month one, from January 1982 through May 2019. This segment of the yield curve inverts before a recession begins. Based on data dating back to 1955, the yield curve inverts, on average, about 15 months before the start of a recession.

The yield curve inverted in March for about five days, then quickly turned positive between the 3-month and 10-year points. Yet the curve inverted again in mid-May and has remained inverted for almost four weeks. By changing the behavior of Senior Loan Officers at banks, the yield curve may actually be a cause of recessions noted by the Federal Reserve Bank of St. Louis in a note published in December 2018. This happens because banks become less risk tolerant, any new loans will be less profitable to banks, and there is a fear of a deteriorating economic environment. This restriction of capital, in turn, reduces business activity and slows the economy.

Another leading indicator of recessions has been unemployment, which has been seen bottoming out approximately six months prior to the start of a recession. Unemployment begins to rise as job losses increase, which makes consumers become more cautious and causes real consumer spending to decline. Since the consumer is approximately 70% of the economy, economic growth slows down, too.

The unemployment rate is at a 50-year low and it can go lower, although we should not expect that to occur. Therefore, the unemployment rate appears to be at or near a cyclical bottom.

The Conference Board’s Leading Economic Indicators Index is a composite index consisting of 10 components, including average weekly hours, worked in manufacturing, S&P 500® stock prices, core durable goods orders (a measure of business spending), building permits, consumer expectation, and the spread between the 10-year Treasury and Federal Funds rate, among others. This index tends to lead the economy by 4-6 months. The index level for April showed an increase of 0.2%, following increases in both February and March. Thus this index is indicating that the economy is expected to continue expanding into the fall. Despite the rise in this index, durable goods orders declined by 2.7% in April and are down over the past seven months. Building permits are flat or down over the past year. What does it mean that we are seeing weakness in different areas of the economy?

A recession can have many causes, and while each recession is different than its predecessors, they do share many similarities. Imbalances build up in an economy which will ultimately be corrected through lower employment, lower consumer and business spending, and falling corporate profits, among other data points. The current expansion is no different. While we can’t always know what the imbalance is, there are several possibilities. One is the huge increase in debt in the system. As an example, the non-financial corporate debt has increased to all-time highs at more than $9.9 trillion dollars, while the U.S. Federal Government debt exceeds $21 trillion. Both the U.S. government and non-financial corporate debt have doubled since the start of the 2008 recession.

Another possible catalyst for the next recession is the trade war. In July 2018, the U.S imposed 25% tariffs on $34 billion of Chinese imports, which China quickly matched. In August both countries added 25% tariffs on another $16 billion of goods, followed by 10% tariffs on $200 billion of imports from China by the U.S., while China countered with 5-10% tariffs on $60 billion of U.S. imports into China. On May 5, President Trump announced that the 10% tariffs will be raised to 25% on $200 billion of Chinese imports, with the threat of increasing tariffs on the remaining imports – and China retaliated in-kind. Early June, President Trump threatened to place tariffs on imports from Mexico. The U.S. is now dealing with tariffs on goods from two major trading partners. A tariff has largely the same effect as a consumption tax since in both cases it is the consumer who ends up paying higher prices. Higher taxes on goods at least temporarily reduce demand, which slows economic growth, and which could be the catalyst sending the U.S. into the next recession.

At the end of May – using data from the New York Federal Reserve – the probability of a recession was at 29.6%. That’s lower than at the start of every recession since 1960 and would suggest that we are not at risk of a recession today. It should be noted, though, that the recession of 2008 only generated a probability of just over 40% yet ended up being the worst recession since the Great Depression.

The economy has been expanding for 10 years, but it has slowed down from the growth rate of mid-2018. Simultaneously, the threat of a recession has increased. The yield curve has inverted and it has remained inverted for almost a month. Business spending and the housing market are flat to down, and consumer spending and retail sales are slowing.

However, the indicators are not yet flashing for an imminent recession. The decline in the equity markets in May prompted members of the Fed to at least hint that a rate cut was possible in the near future, which would push a recession off even further into the future. Nevertheless, we are already more conservatively positioned in client accounts due to our reduced equity market expected returns and due to our adherence to our possible downside exposures.

Frontier’s investment process is most concerned with the performance of capital markets, which often act in advance of and independently of actual after-the-fact economic events. Equity markets can lead the economy, as investors are constantly looking forward and pricing securities based on expectations. As it stands today, Frontier does not hold an opinion on or act upon whether we “think” a recession is about to occur. After all, equity markets will likely respond poorly far in advance of an actual recession. Recessions are not something to fear, they are a normal correction mechanism for an imbalanced economy, and our time-tested process has excelled at surviving many adverse outcomes, as well as positive ones too.


May 2019 Strategy Review

By Gary A. Miller, CFA

May looked more like the slumping-markets’ fourth quarter of last year than it did the market’s rally of the first four months of this year. Economic slow-down worries caused by actual data and more trade and tariffs talk sent stocks plummeting around the world. The S&P 500® Index of U.S. large stocks lost over six percent in May, and the Russell 2000 Index of U.S. small stocks lost nearly eight percent. International markets fared a little better as the MSCI EAFE Index of developed markets stocks lost a little less than five percent. However, emerging markets, which include China and Mexico, the two countries impacted most directly by U.S. trade talks, lost over seven percent.

High quality fixed income reacted according to textbook; with all the talk of economic slowdown, bond yields fell dramatically. The bell-weather ten-year Treasury note yield fell from an already low 2.51% all the way down to 2.14%. The huge drop in yields, of course, led to much higher prices; the Bloomberg Barclays Aggregate Bond Index returned 1.8% in May, while the Bloomberg Barclays Long-term Treasuries Index returned a whopping 6.5%. The huge drop in yields in the month and the extraordinary returns indicate the bond market is even more pessimistic about the economic outlook than the stock market. Also, by month-end one of the best, if not the best, economic recession indicator flashed red. The huge rally in Treasury prices and a commensurate drop in yields pushed the 10-year Treasury note yield below the 2.35% yield of the 3-month T-bill. This condition, called an inverted yield curve, has an ominous record of predicting recessions and stock market sell-offs.

It should not be a surprise that Frontier’s Globally Diversified Strategies were down across the board in May. That’s the bad news. The good news is that they fell noticeably less than their respective benchmarks. That should not be a surprise either since these strategies have been conservatively positioned for a while now and our favorite equity-hedging asset class, long-term Treasuries, did even better than we might have expected considering the extent of equity markets’ declines. As a bonus, mutual fund performance also added value over indexes in the month. Year-to-date the equity-dominated strategies (Balanced through Global Opportunities) have solid positive returns that exceed their benchmarks as mutual fund added value more than made up for the return shortfall due to the conservative asset allocation mixes. Higher returns with lower risk; we like that! The more conservative, fixed income-dominated strategies still trail their benchmarks year-to-date as the smaller added value from their mutual fund holdings has not quite made up for the very conservative posturing of these strategies. Longer-term performance across strategies and across time-periods continues to be better than benchmark with few exceptions.

Frontier Asset Management’s unconstrained Alternative Strategies were also down in May and fell a little more than the HFRX Absolute Return and Global Hedge Fund Indices, which had a relatively good month considering the downtrend in stocks. The good performance of hedge funds in the month was perhaps a bigger reason for Frontier’s shortfall than the performance of the Frontier strategies since the Frontier strategies’ losses were smaller than the comparable Globally Diversified strategies. Year-to-date, though, the Alternative Strategies are well ahead of the hedge fund comparable indices. Performance of the Alternatives Strategies continues to look favorable relative to the hedge fund universe and alternative strategies available in mutual fund formats over longer-term horizons.

Leading Economic Indicators

Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. All calculations of performance are by Frontier.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice.  Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Data sources for funds and indices are Morningstar, the Hedge Fund Research Institute and BarclayHedge. Other sources include: National Geographic.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance.  References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind.  This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or over compensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back-tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision making process if the firm were actually trading clients’ accounts.  Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns, or returns that equal either the hypothetical expected results reflected or any corresponding benchmark presented.  In addition, performance can, and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information. For any investment products mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.
It is generally not possible to invest directly in an index*. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
MSCI All Ciuntry Index ex-US
The MSCI ACWI ex-USA is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI ex-USA consists of 44 country indices comprising 23 developed and 21 emerging market country indices.
Barclays Capital Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value
Benchmark Composition. The Benchmarks for the Long-Term Growth, Growth & Income, Balanced, Conservative and Capital Preservation strategies are combinations of the Wilshire 5000 Total Market Index, MSCI All Country World ex US Index, Bloomberg Commodity Index, HFRX Global HF Index, Barclays US Aggregate Bond Index and 3-Month T-Bills.
The blends of the indices are currently:
Capital Preservation Bench
Conservative Bench
Balanced Bench
Growth & Income Bench
Long-Term Growth Bench
Wilshire 5000
MSCI AC World ex US
Bloomberg Commodity
HFRX Global HF
Barclays US Agg
3M T-Bills
Benchmarks for the Global Opportunities, Focused Opportunities, Absolute Return Plus, Absolute Return and Short-Term Reserve strategies are the MSCI World, S&P500®, HFRX Global HF, HFRX Absolute Return and Barclays Capital 1-5 Year US Treasury Indices, respectively. In the case of indices that include foreign securities, index returns are still presented on a total return basis but will be net of foreign taxes on income generated by these securities.
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