July 2019
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

Earlier this year, my daughter asked me, “Dad, can you believe it, in a few months, I’m going to graduate high school and be off to college.” Because my brain is dominated by its logical side, my response was “Well, that has pretty much been the plan since the day you were born; so yes, I can believe it.”

Unlike the well-defined progression of a career through school, that allows you to accurately forecast the date of graduation soon after the first ultrasound, the economy is much less predictable. While it does follow a certain rhythm, consistently ebbing between periods of expansion and contraction, no one schedules a party 8 months in advance to celebrate a peak or a trough that they know is coming at a specific time. In fact, you don’t know that you have changed from an expansion to a recession (or vice-versa) until several months after the change has taken place. The commonly held definition of recession is 2 consecutive quarters of declining GDP growth.

We are currently in the midst of the longest economic expansion in U.S. history, 120 months and counting. This period of growth began back in the summer of 2009, when my recent high school graduate had finished second grade. By the way, this year’s senior class marks the last class composed of people born in a pre-9/11 world (see chart below).

US Expansion chart 7.2019

The shear length of the expansion leads investors to wonder when it will end, and most assuredly, it will end. In the financial media, this frequently leads to an analogy not about grades in school, but a baseball comparison about which inning we are in.

While this cycle is old, expansions do not die of old age, something kills them. The current phase did not bring with it the excesses that previous boom periods brought which might have us bracing for impact. The most recent 2008 recession was a result of excess debt in the housing market. The 2001 recession followed an asset bubble in technology stocks.

Economic data indicates that while things are slowing, a recession does not appear imminent. Valuations are higher than average, but not ridiculously so (see chart below).

Valuations 7.2019

Consider the sectors of Housing, Business investment, Vehicle sales, and Inventories. Together these areas comprise about 40% of U.S. GDP. As mentioned previously, usually a recession comes from a boom sector going bust; but as you can see from the chart, none of these sectors are near their all-time highs (see chart below).

Cyclical Sectors 7.2019
This data is a proxy for what we are seeing across the board: the good news is that there isn’t a clear risk of something busting, but the bad news is that trends are stabilizing, and additional growth will be harder to obtain.

Illustrative of the economy’s future growth challenges is the employment picture. At an unemployment rate at a low 3.6%, there aren’t many workers yet to employ to fuel productivity. As wages rise in competition for a limited supply of workers, this will cut into corporation’s profit margins and will be a headwind for earnings growth (see chart below).

Unemployment 7.2019
Despite the increase in wages, overall inflation has remained below 2% due to both oil prices and the value of the Dollar moving sideways.

Manufacturing is another area where we are seeing data softening; certainly related to uncertainty surrounding tariffs and trade talks (see chart below).

Manufacturing 7.2019Source: WSJ/Daily Shot

Another concern is the widely cited recession indicator of an inverted yield curve; where short-term interest rates are higher than long-term rates. While this situation has preceded every recession in the past 50 years, there is a wide disparity as to how long it takes for a recession to start once the yield curve inverts. While there has been some short-long inversion, the closely watched 10-year rate 3.04% in 12/31/13 and 2% in 6/30/19) vs 2-year rate (.38% in 12/31/13 and 1.75% in 6/30/19) has not yet inverted. We view this not as a sign to panic, but a further indicator that we are getting later in the economic cycle (see chart below).

Yield Curve 7.2019

The monetary policy implemented by the Fed (Federal Reserve Board) has done its part in extending the period of expansion. With Chairman Powell’s words “The case for a somewhat more accommodative policy has strengthened,” the market took another leg upward as it anticipated this to mean that interest rate cuts are coming. Yet another good news/bad news situation. The stock market likes lower rates (encourages borrowing and business investment) but the fact that they are coming in response to worsening economic data is not something to cheer.

Meanwhile, the stock market has continued to move higher, not quite as robust as the relief rally we saw in the first quarter, but still setting new record highs. The Financial sector was the top performer while Energy was the laggard as the only sector that was negative.

Index      1st Qtr 2018      
Return
1 Year
      Return        
3 Year
     Annualized      
Return
5 Year
     Annualized      
Return
S&P 500 4.3% 12.4% 14.2% 10.7%
Nasdaq Composite 3.9% 15.4% 19.6% 14%
Russell 2000 – Smaller Companies 2.1% -3.3% 12.3% 7.1%
MSCI EAFE – International 3.7% 1.1% 9.1% 2.2%
Barclays US Aggregate Bond 3.1% 7.9% 2.3% 2.9%

Regarding portfolio management, we at Castle will continue to monitor the increased risks of recession and look for opportunities to incrementally and gradually make portfolios slightly more conservative. Our diversified portfolios are intended to have a certain all-weather quality to them so we would not anticipate making wholesale changes, but we do not want to miss the opportunity to capture some of the gains that have been achieved and reduce the overall risk as the inevitable coming recession creeps ever closer.

We expect the coming months to be dominated by talk of rate cuts, trade tensions, the 2020 elections (with the potential market implications for healthcare and technology), and the ability of corporations to continue to increase earnings. Thanks for letting us be a partner on this journey.

Wishing you a safe and happy summer. Here’s to graduations, new beginnings, rain stopping, vacations, freedom, and the opportunity to live in the greatest country in the world.

 DarrenSignature

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.

Earlier this year, my daughter asked me, “Dad, can you believe it, in a few months, I’m going to graduate high school and be off to college.” Because my brain is dominated by its logical side, my response was “Well, that has pretty much been the plan since the day you were born; so yes, I can believe it.”
Unlike the well-defined progression of a career through school, that allows you to accurately forecast the date of graduation soon after the first ultrasound, the economy is much less predictable. While it does follow a certain rhythm, consistently ebbing between periods of expansion and contraction, no one schedules a party 8 months in advance to celebrate a peak or a trough that they know is coming at a specific time. In fact, you don’t know that you have changed from an expansion to a recession (or vice-versa) until several months after the change has taken place. The commonly held definition of recession is 2 consecutive quarters of declining GDP growth.
We are currently in the midst of the longest economic expansion in U.S.  history, 120 months and counting. This period of growth began back in the summer of 2009, when my recent high school graduate had finished second grade. By the way, this year’s senior class marks the last class composed of people born in a pre-9/11 world (see chart to the right).
The shear length of the expansion leads investors to wonder when it will end, and most assuredly, it will end. In the financial media, this frequently leads to an analogy not about grades in school, but a baseball comparison about which inning we are in.
While this cycle is old, expansions do not die of old age, something kills them. The current phase did not bring with it the excesses that previous boom periods brought which might have us bracing for impact. The most recent 2008 recession was a result of excess debt in the housing market. The 2001 recession followed an asset bubble in technology stocks. 
Economic data indicates that while things are slowing, a recession does not appear imminent. Valuations are higher than average, but not ridiculously so (see chart to the right). 
Consider the sectors of Housing, Business investment, Vehicle sales, and Inventories. Together these areas comprise about 40% of U.S. GDP. As mentioned previously, usually a recession comes from a boom sector going bust; but as you can see from the chart, none of these sectors are near their all-time highs (see chart below). 
This data is a proxy for what we are seeing across the board: the good news is that there isn’t a clear risk of something busting, but the bad news is that trends are stabilizing, and additional growth will be harder to obtain.
Illustrative of the economy’s future growth challenges is the employment picture. At an unemployment rate at a low 3.6%, there aren’t many workers yet to employ to fuel productivity. As wages rise in competition for a limited supply of workers, this will cut into corporation’s profit margins and will be a headwind for earnings growth (see first chart on the next page). 
 
Despite the increase in wages, overall inflation has remained below 2% due to both oil prices and the value of the Dollar moving sideways.
Manufacturing is another area where we are seeing data softening; certainly related to uncertainty surrounding tariffs and trade talks (see chart to the right).  
Another concern is the widely cited recession indicator of an inverted yield curve; where short-term interest rates are higher than long-term rates. While this situation has preceded every recession in the past 50 years, there is a wide disparity as to how long it takes for a recession to start once the yield curve inverts. While there has been some short-long inversion, the closely watched 10-year rate 3.04% in 12/31/13 and 2% in 6/30/19) vs 2-year rate (.38% in 12/31/13 and 1.75% in 6/30/19) has not yet inverted. We view this not as a sign to panic, but a further indicator that 
we are getting 
later in the 
economic cycle (see 
chart to the right).
The monetary policy implemented by the Fed (Federal Reserve Board) has done its part in extending the period of expansion. With Chairman Powell’s words “The case for somewhat more accommodative policy has strengthened,” the market took another leg upward as it anticipated this to mean that interest rate cuts are coming. Yet another good news/bad news situation. The stock market likes lower rates (encourages borrowing and business investment) but the fact that they are coming in response to worsening economic data is not something to cheer.
Meanwhile, the stock market has continued to move higher, not quite as robust as the relief rally we saw in the first quarter, but still setting new record highs. The Financial sector was the top performer while Energy was the laggard as the only sector that was negative.
Index 4th Qtr 2018 Return 1 Year Return 3 Year
 Annualized
 Return 5 Year 
Annualized Return
S&P 500 4.3% 12.4% 14.2% 10.7%
Nasdaq Composite 3.9% 15.4% 19.6% 14%
Russell 2000 – Smaller Companies 2.1% -3.3% 12.3% 7.1%
MSCI EAFE – International 3.7% 1.1% 9.1% 2.2%
Barclays US Aggregate Bond 3.1% 7.9% 2.3% 2.9%
 
Regarding portfolio management, we at Castle will continue to monitor the increased risks of recession and look for opportunities to incrementally and gradually make portfolios slightly more conservative. Our diversified portfolios are intended to have a certain all-weather quality to them so we would not anticipate making wholesale changes, but we do not want to miss the opportunity to capture some of the gains that have been achieved and reduce the overall risk as the inevitable coming recession creeps ever closer.
We expect the coming months to be dominated by talk of rate cuts, trade tensions, the 2020 elections (with the potential market implications for healthcare and technology), and the ability of corporations to continue to increase earnings. Thanks for letting us be a partner on this journey.
Wishing you a safe and happy summer. Here’s to graduations, new beginnings, rain stopping, vacations, freedom, and the opportunity to live in the greatest country in the world.