A Recession is Not on the Clock

Dear Fellow Shareholders:

My comments this quarter will not differ much from my comments for the last several quarters. The bottom line is that our economy continues to chug along just as it has for the past decade. Many fear that the very length of the expansion we are enjoying will bring about its demise. But the end of our current expansion will not be due to its length. A recession is not on the clock. Instead, the expansion will eventually end due to excesses which have built up during the expansion.

The current expansion owes its longevity to several small, mid-course corrections. These pauses refreshed the economy. The most recent lull was the oil patch turmoil of ‘15 and ‘16 brought about by the 75% plunge in oil prices from over $100 to about $25 per barrel. Although this episode led industrial production to decline for six quarters, the Gross Domestic Product (GDP) of our service-dominated economy continued to grow. Nonetheless the pause led to more conservative economic and financial decisions; instead of continuing to mount, exuberance took a step back.

In fact, there are some signs that we may now be undergoing another mid-course correction. Potential trade wars have disrupted global supply chains. Companies have stockpiled needed supplies to avoid potential tariff hikes. This buy-in-advance behavior has led to declines in new orders. In turn, this decline has forced production cuts by a wide range of technology companies. Caution rules the day. Capital spending is being held in check. Lenders are wary.

As with the oil patch episode, I believe that our service-oriented economy will be able to overcome current trade woes. New jobs are still being created. Employment is at new highs. Paychecks continue growing. Personal income is at record levels. Inflation remains at bay. Green lights abound. For now, most systems are go.

So what could derail our expanding economy? In prior letters I have noted potential problems beyond just economic excesses. They are worth revisiting.

My biggest concern is the unknown side effects of our current easy money policies. These policies arose in the aftermath of the global financial crisis (GFC) meltdown. As they have no historical precedent, their ultimate impact is not understood. The usual prescription for treating a recession is an even mixture of fiscal and monetary policies. Instead, we treated the GFC with a bit of fiscal policy and a bunch of monetary policy. Inexplicably, we continued to employ easy money long after the recovery from the GFC was assured. And this isn’t merely a U.S. policy, it is global. An indication of just how easy global money is, are the previously unheard of levels of negative interest rates. Currently the value of funds “invested” at negative rates exceeds 13 trillion dollars, up from zero five years ago.

The obvious danger of easy money is inflation. But to date, inflation has not been a problem. In fact, the Federal Reserve (Fed) has had difficulty getting inflation up to their 2% target level. It is worth restating that the “so far, so good” impact of easy money should not be used to predict the future. We just don’t know how our current easy money policy will play out. But we do know that easy money has led to problems in the past.

One sign of potential problems is the Fed’s thwarted effort to end easy money by raising rates. Four years ago the Fed became concerned that easy money was lead to rising asset prices. To bring bond (and stock) prices in check, the Fed initiated a rate increase. Before the increased rates had been held at the 0.25% level for the seven years since the depths of the GFC.

The Fed continued increasing rates through the end of last year. But when continued rate increases caused bond and stock prices to falter, the Fed met political and theoretical pushback. Fear of upsetting the economic applecart led the Fed to halt their rate increases. In fact, many are expecting the Fed’s next move to be a cut, leading to soaring bond and stock markets. A relevant analogy may be addiction. The Fed is trying to quit easy money, but is too afraid of the “withdrawal symptoms” to follow through.

Another little-discussed threat to our economy, or at least the stock market expansion, is clear air turbulence — a phenomenon I have commented on previously. Similar to an airplane which encounters an unexpected patch of rough air, we’ve had episodes of market turmoil which have no apparent cause. In hindsight, these “flash crashes” are treated as aberrations unlikely to recur. Many pin flash crashes on the rise of automated trading. Automated machine-to-machine trades occur without benefit of human interaction. This sometimes leading to nonsensical price movements.

While not termed flash crashes, other instances of extreme price fluctuations affect the market. In early ‘18 the market fell 10% in less than a month with no obvious cause beyond the normal headlines. Again late last year, without clear explanation, the market fell 20% during the fourth quarter. This year began with a strong 25% recovery from the December ‘18 low. While these recent episodes of market volatility have been contained, there is no assurance that they won’t reach a tipping point in the future.

Another policy we are trying for the first time is cutting taxes while the economy is already in an expansion mode. Tax cuts are normally reserved for helping an economy to escape the depths of a recession. They offer a form of pump priming to get the economy moving again. The current tax cut has provided additional economic tailwind. But it has also increased deficits at a time when deficits would normally be shrinking. This raises concerns that the deficit might balloon should we go into a recession.

In addition to these new types of risk, geopolitical risks are ever present. Most of the time these risks neither come to fruition nor pose a serious threat. Perhaps the major current geopolitical risk is the demise of the Euro. While this is not much talked about, flare ups are frequent. Brexit is a manifestation of questions about the Euro. The fundamental problem is that a monetary union without a government union, including a common budget, is inherently precarious. The Brexit movement exists due to resistance to laws made by faceless and unelected EU delegates. Arguably the woes in Italy stem from its inability to properly value its currency due to its adoption of the Euro.

This is particularly true when the fundamental issues stretch beyond trade. The threat of imposing tariffs on Mexico to staunch the flow of immigrants is a perfect example of the expansive use of trade policy. The fundamental issue with China also extends well beyond trade.

Trade wars represent another geopolitical risk. To date they have led to much more smoke than fire. But the concern is always that trade affairs can flare into an all-out beggar thy neighbor war. This is particularly true when the fundamental issues stretch beyond trade. The threat of imposing tariffs on Mexico to staunch the flow of immigrants is a perfect example of the expansive use of trade policy. The controversy with China extends well beyond trade to concerns about respect for intellectual property. Is using trade policy as a one size fits all approach to international problems really a good idea?

Threat of armed retaliation for attacks on ships in the gulf and the downing of a drone serves as a reminder that actual conflict is always a geopolitical threat.

This lengthy list of things which could go wrong does not insure that anything, in fact, will go wrong. I discuss them to remind investors that problems may arise in unexpected places even when the economy is humming along. Caution is always a beneficial attribute for an investor to have. That said, I am generally sanguine about my outlook for the economy and the market. I expect our current slowdown will help revitalize the economy. I don’t expect a recession merely due to the extended length of our current recovery.

Sincerely,

Sam Stewart,

Partner

This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.

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