Where's the recession?

RBC's Eric Lascelles helps us make sense of the mixed signals in the market today

Ruth Saldanha 8 October, 2019 | 2:39AM
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Ruth Saldanha: With escalating trade tensions and inverted yield curve in the U.S. and a prolonged expansion, there is increasing speculation that we might be headed into a period of slowing growth and possibly a recession. But is it likely? Though this isn't his best case forecast, RBC Global Asset Management's Chief Economist Eric Lascelles argues that in the best case scenario, arguments could be made that support the current economic expansion continuing for several more years. But should you make your investment decisions based on that? Eric is here today to explain his point of view.

Eric, thank you for being here today.

Eric Lascelles: Thank you for having me.

Saldanha: Most of the key indicators point towards a recession. But that hasn't happened yet. So, what's holding this economic cycle up?

Lascelles: Well, I think, to begin with, it's worth recognizing there are some fairly different aspects to the economy today. And so, we're all very focused, of course, on a manufacturing sector that clearly is in decline almost globally. Let's equally acknowledge that the consumer sector is actually held up fairly well. So, there's a real mix of stories and perhaps not all in quite the state of decline as one would first imagine. Of course, we've seen inverted yield curves, and that is a classic recession signal. But let's acknowledge two things about that.

The first is that even when you get that signal, and even when it's telling the truth, historically, there has been about a year between the signal triggering and actually falling into recession. And so, in that sense, it perhaps is no great surprise that a recession hasn't happened quite yet. But equally, and again, focusing on the yield curve, it's equally worth acknowledging that there are some different things about the yield curve perhaps today than in past cycles. And maybe the most obvious one is that there's no real term premium that we can find in the bond market. And in theory, if you have no term premium, you need that yield curve to invert by notably more than we've seen so far. So, you could argue whether the signal is actually fully triggered. And so, I think that's at least part of the story why we haven't stumbled into a recession just yet.

Saldanha: You have three main scenarios, your best, base and worst case scenario. Let's start with the worst. What's your worst case scenario from here on?

Lascelles: Well, I think the worst case scenario is simply that the yield curve is absolutely telling the truth. And maybe we even see a recession come towards the sooner versus the later end of the historical range. And so, I guess, recession is the answer to that question. But equally, I would acknowledge, even if we were to stumble into a recession in the extreme near term, in a worst case scenario, it still seems unlikely to be as dire as the one from a decade ago. We just don't have the same sort of financial market imbalances that that pervaded at that moment.

Saldanha: And then, what's your best case scenario?

Lascelles: Well, the best case scenario is an interesting one. And again, Let's not argue it's the most likely; somewhere in the middle is, in fact, most likely. But I think the best case scenario just doesn't get much attention. So, it's interesting to draw that out for a moment. And so, really, the best case scenario is just that this expansion keeps going. And so, people have written it off. And indeed, it is fairly likely that it comes to a close over the next year or so. But this thing could keep going, the expansion could continue. In terms of why it could continue, some might have to do with that yield curve analysis we just engaged in. Possibly that signal is distorted this time around. A fair bit has to do with the notion that perhaps there's more economic slack in the world than we currently think. Certainly, unemployment rates are very low. But other metrics aren't quite confirming that signal. And there are a lot of discouraged job seekers perhaps still at the periphery who prevent the overheating that often triggers a recession. And then, lastly, and I mentioned this for a moment just a minute ago, it's not obvious that there are the big financial imbalances that historically have often triggered recessions. And I wouldn't want to suggest you can't have a recession without one of those. But those tend to be the triggers and they tend to trigger some of the deeper recessions. And we can, of course, find imbalances when we look but they're not on the scale of the world's biggest housing market being in something of a bubble. It's just not that big this time round. So, this expansion could just continue. We might check in in three years, and possibly, it's still going.

Saldanha: But in your opinion, which is more likely, an expansion or a contraction right now?

Lascelles: Gee, it's a good question. And so, I guess, I would say, if you're talking about over the next year, I'd say an expansion is still more likely. Maybe it's a 60% chance versus a 40% chance, so hardly a slam dunk by any means. But most of the time, economies grow, they are built for growth, that is the natural state of affairs. You have productivity rising, you have more workers coming into the system. And so, it's a fairly rare occurrence to suffer the reverse. But equally, the risk of a downturn is bigger than it usually is. So, normally, perhaps your odds are 80% or 90% expansion and 10% or 20% recession. And here we are maybe sitting in more of a 60%-40% proposition right now.

Saldanha: So, what should investors do right now?

Lascelles: Yeah, so that's the challenge. And of course, they need to factor in all sorts of different considerations ranging from the level of interest rates to stock valuations, to the macro trend. And of course, the longer one's investing time horizon, the less one has to fret about the short term. And so, those with the luxury of decades of investing can probably ignore just about all of this and just sail on their merry way. One of the things that we've done, recognizing the lateness of the cycle, the higher than usual recession risk is, we are taking less investment risk than we normally do. And so, we're still very happy to own stocks. We think stocks will generate the superior long-term return. They do have a better valuation versus bonds right now as well as it happens. But if you see a bigger than usual recession risk, clearly, that's the obvious counterpoint. And so, we're taking less risk than usual. It's not a heading for the hills moment. It's very much we're closer to our neutral allocation having taken more risks earlier in the cycle. And that does mean holding a little more in fixed income, holding a little bit more in cash as well. But in a world in which cash doesn't return very much and fixed income doesn't offer you much more than that, if at all these days, it's not a time for going heavily into bonds either.

Saldanha: Thank you so much for joining us today, Eric.

Lascelles: Thank you.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha

Ruth Saldanha  is Editorial Manager at Morningstar.ca. Follow her on Twitter @KarishmaRuth.


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