When the expansion will end—and how to protect portfolios

Though market volatility in early February motivated plenty of speculation about the cycle’s end, some are willing to put their fears to rest.

“Don’t fear the recession reaper this year,” says BMO senior economist Sal Guatieri, in a weekly financial digest.

However, at the same time, he has a warning: “Investors would be wise to keep a close eye on the inflation embers for signs of sparks.”

Here’s a look at why investors should heed that warning.

Taking measure of the expansion

Guatieri forecasts that the expansion could last until July 2019, at which time it will be the longest on record.

“We would wager that the odds on this scenario are much better than even—but far from a lock,” he says.

He notes that expansions end because of imbalances in credit, asset, or product and labour markets.

“Households and companies take on too much debt, investors push asset prices far beyond fundamental value, or goods and labour shortages stoke prices and drive up interest rates,” he says. All three caused the 2008 recession, in the form of a credit crisis, a housing bubble and an inflation-led jump in interest rates.

A credit crisis is the least likely to spur the next recession, says Guatieri, because private sector debt remains below its trend line.

A correction in asset prices is a greater risk, but likely only if equity and house values climb sharply further, he says. Equities are expensive, he adds, but that alone isn’t sufficient to end a bull market or trigger a recession.

That leaves a material rise in inflation and interest rates to trigger the expansion’s end—”but not this year,” says Guatieri.

That’s because inflation will take time to appear, given that borrowing costs are below neutral and the yield curve is steeper than normal, he says.

“The inflation pot will also take longer to boil today than in the past given the cooling effect of e-commerce, automation and the gig economy,” he adds. He expects core CPI to rise only moderately to 2.2% this year, slightly above the Fed’s target rate.

“Even if inflation climbs faster, it will take time for the Fed to realize that the kettle is boiling over before it shuts off the gas, and some time for rates to increase sufficiently to invert the yield curve,” he says. “Most likely, the expansion will keep going for another [one-and-a-half] years, breaking the record for longevity set in 2001.”

A caveat to his outlook: if core inflation is closer to 3%, all bets are off.

To explain why, Guatieri observes that U.S. fiscal stimulus and tax reform are coming along at a time when the economy has little slack, oil prices are above $60, the U.S. dollar is sagging and politics focuses on protectionism.

“The former two factors will heat up domestic prices, while the latter two drive up import costs,” says Guatieri. “If the Fed is forced to raise policy rates sharply to douse inflation (also boosting the dollar and hammering stocks), a recession could occur, possibly in 2020.”

In the same report, BMO senior economist Robert Kavcic notes that the test for stocks right now is part technical, part fundamental.

On the technical side, “the S&P 500 bounced hard off its 200-day moving average in early February, but [last] week was firmly turned back by the 50-day average,” he says. “Regardless of how much faith you put in these metrics, they do appear to be having some effect right now.”

When in comes to fundamentals, U.S. fiscal stimulus is hitting a capacity-constrained economy, which will lead to “more meaningful Fed tightening, which ultimately rolls the economy over down the road,” says Kavcic. “The question is, how far down that road do equity investors want to look?”

Checking your portfolio for rate sensitivity

If benign inflation and low or lowering bond yields are finally starting to reverse, investing strategies that worked well in the past few years won’t work well in the coming quarters, says a report by Richardson GMP.

Read: Are fixed income fears unfounded?

For example, many investors have flocked to interest rate sensitives for steady dividends, decent capital appreciation and relative stability.

“This has led many portfolios to be very heavily weighted to these sectors and as a result very sensitive to changes in yields or interest rates,” says the report. “We believe it is prudent to gauge how interest rate sensitive your portfolio may be in light of a potentially changing market.”

Diversification across asset classes isn’t enough.

“A portfolio comprised of products, equities, funds and bonds that are more interest rate sensitive may not be as diversified as it would appear on the surface,” says the report.

Read: Your guide to inflation-proofing clients’ lives

Historically, the most sensitive interest rate bonds and sectors include Canadian bond universe, Canadian corporate bonds, Canadian short bonds, golds, telcos, REITs and utilities. Least sensitive include insurance, energy services, S&P, capital goods, energy exploration and production, and energy intergrateds. (See the report for a full list.)

Read: The case for high-yield bonds amid rising rates

“By no means are we suggesting dividend- or income-focused investor[s] abandon the interest rate sensitives,” says the report. “However, ensuring you have a better balance would really help performance—assuming this plays out to the higher end on yields and inflation.”

Read the full reports from BMO and Richardson GMP.

Also read:

Fixes for fixed income as rates rise

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