Quick Thoughts: How To Avoid Making A Unicorn Skeleton

Articles From: Franklin Templeton
Website: Franklin Templeton

By:

Chief Market Strategist and Head of Franklin Templeton Investment Institute Franklin Templeton

Stephen Dover, Head of Franklin Templeton Institute, crunches the data to decipher the odds of a US recession this year and the implications for investor portfolios.

In 1663 a strange skeleton was found in a gypsum quarry near the mountain town of Quedlinburg, in present day Germany. The discovery caught the attention of Otto von Geuricke, a Prussian scientist, who concluded that the incomplete skeleton was a unicorn. The skeleton, dubbed the Magdeburg Unicorn, was obviously not actually a mythical beast. It was a composition of bones from several different prehistoric animals.1

The Magdeburg Unicorn is a reminder of the problems that can occur with an incomplete picture. At Franklin Templeton, we invest heavily in gathering data, crunching numbers, building models, and trying to make sense of the deluge of information that bombards us daily. In the modern world, data capture and systematic data analysis are an important part of making informed judgements that help us meet our fiduciary responsibilities.

The topic at the top of everyone’s minds as we start 2023: Is the United States headed into recession, and how will my investment portfolio be impacted? One tool the Franklin Templeton Institute employs to better assess how to answer these questions is a Nowcast model.2

What indicators are we watching

While there are several Nowcast-style models, developing our own brings us closer to the data. Our Nowcast index is constructed based on 153 economic and financial indicators from the following categories: manufacturing, labor, consumer, housing and construction, liquidity, and financial conditions. Looking at the most recent readings of many economic indicators, nowcasting gives a more up-to-date reading of the economy than gross domestic product (GDP).

Currently, all categories are contributing to the ongoing US economic slowdown, which is also becoming more pronounced. Several indicators are particularly worrisome. Consumer sentiment is near five-decade lows. The gap between current and future sentiment readings, which is typically a good recession indicator, is elevated. More recently, manufacturing sentiment has deteriorated. The global manufacturing purchasing managers’ index (PMI) dropped below the expansion/contraction line of 50 (to 48.6) in December, while ISM manufacturing index also dipped to a “stall-speed” of 48.4 in December.

The weakest US sector is housing. Building permits have been on a downward trend for much of 2022 and dropped again in December, as did existing home sales. Sentiment among builders of US single-family homes has been deteriorating for 12 consecutive months. Home prices have recently begun to decline in many US regions.

The US labor market has been an outlier of resilience. The prime-age unemployment rate is 3% and job growth remains solid, as shown by a net 199,000 nonfarm payroll jobs added in December. To be sure, labor market indicators typically lag overall activity. But the jobs market is also holding up given supply shortages—as of November, job vacancies outstripped jobseekers by a ratio of 1.8.  However, we are starting to see cracks here as well as the labor component turned negative for the first time in December.

US recession looks more probable today than at any time since 1970

Armed with information that shows the US economy slowed significantly in 2022, what lies ahead? What are the odds that a slowdown turns into a full-blown recession?

Perhaps the most used and statistically significant recession probability variable is the shape of the US yield curve. The US Treasury curve is now inverted, in the sense that two-year note yields of 4.22% are higher than 10-year yields of 3.49%.3 That’s unusual—typically investors require higher yields at longer maturities.

An inverted yield curve typically precedes recessions. But as our work shows, the probability of a recession increases the more different maturities along the yield curve are inverted. Based on a deeper historical statistical analysis, the probability of a recession nears 100% if more than 50% of the maturity spreads along the yield curve are inverted, as is the case today.

History also provides plenty of data about how other variables typically behave before recessions. Our work also points to a leading relationship of broad stock market returns and recessions, with large and sustained negative equity market returns often (if not always) preceding recessions.

By gathering and analyzing a lot of data we can employ elementary statistics to estimate probabilities of future outcomes. We can also neatly compile a plethora of different data sources with recession-forecasting significance into a single index, which we present in the chart below. Currently, our recession probability index is beyond ”amber”—it is flashing ”red.” In our analysis, a US recession looks more probable today than at any time since 1970.

US Recession Model: Probability of Recession Within 12 Months

How should investors position?

These quantitative methods provide a basis for how portfolios might be optimally positioned depending on the current environment. Utilizing this framework plus the collective wisdom and experience of 1,300 investment professionals at Franklin Templeton across asset classes, gives us additional intelligence on what this might mean for investors.

It is important to distinguish between investor types. Very long-term (endowment style) and risk-tolerant investors will face different decisions than those who are either risk averse or anticipate the need for liquidity in the near term. The former may use any market dislocations that occur when recession looms to opportunistically look for value. The latter may want to consider a near-term reallocation to safer instruments. A third type of investor, one looking to add extra return from tactical asset allocation, will focus on opportunities to switch between asset classes. In short, there is no ”one size fits all” answer for investors.

Nevertheless, a few observations can be made that may serve most investors, irrespective of their risk tolerance, return objectives, liquidity needs or other considerations:

  1. Government bonds provide a safer haven. If the US economy is moving toward recession, government bonds (i.e., US Treasuries) are likely to produce positive returns. Weak growth (or recession) reduces private sector borrowing demand and hence tends to push down real interest rates. Inflation is more likely to fall than rise, further lowering bond yields. Risk aversion also tends to drive many investors out of corporate assets and into Treasuries as recessions unfold.
  2. Corporate profits will almost certainly fall in absolute terms if the economy dips into recession. There has never been a US recession in US postwar history when the S&P 500 Index or National Income and Products Accounts (NIPA) measures of corporate profits did not shrink. That should concern investors, insofar as the consensus of company analysts (as collected by FactSet) expects US corporate profits to rise in 2023. If analysts are forced to significantly downgrade earnings forecast, stocks are likely to struggle.
  3. Corporate bond default rates are likely to rise in 2023. After more than a decade of cheap finance, the combination of higher interest rates in 2022 (due to aggressive Federal Reserve rate hikes) and weak economic activity will lead to a deterioration of credit quality. If the past is a good indicator, the spread between corporate bonds and Treasuries is likely to widen. Careful selection of credit risks will be increasingly important.

In summary, for long-term, risk-tolerant investors, the abovementioned outcomes should present opportunities in equities and corporate credit. But for more risk-averse investors, those anticipating liquidity needs and those looking to opportunistically exploit cyclical market moves, it is probably best to consider safer government bonds.

Stay tuned as we bring you more insights from our quantitative studies and independent investment teams in the coming year.

We want to acknowledge the efforts of Lukasz Kalwak, CFA, and Karolina Kosinska, the architects of Franklin Templeton Institute’s Nowcast model.

Originally Posted January 20, 2023 – Quick Thoughts: How to avoid making a unicorn skeleton

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1. Source: Atlas Obscur, “Guericke-Einhorn,” October 2022.

2. Source: Bańbura, Giannone, Modugno and Reichlin, “Now-casting and the real-time data flow, European Central Bank, July 2013. “Nowcasting” is the linguistic contraction of “now” and “forecasting,” with origins in meteorology. In economics, it refers to the study of the present and the very near future, typically current quarter GDP and inflation.

3. Source: St. Louis Fed (FRED data). As of January 13, 2023.

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