Worried about recession? Try this tip

With slower global growth ahead and the business cycle getting old, investors might be worried about a potential recession and wonder how best to position their portfolios. Those worries can probably be set aside, because economic insight provides optimism for further—albeit likely modest—market gains.

First, investors should know that looking to past recessions and their economic environments isn’t much help as a way to forecast the next recession. “We can’t look back at periods in which China was in a trade war and Canadians had this much debt,” said CIBC chief economist Avery Shenfeld in a weekly economics report.

Instead of looking for historical recessionary signs, Shenfeld suggests investors assess market expectations, which are a key starting point to know whether what’s priced in is “too optimistic or too gloomy, and if so, what asset classes might be too rich or cheap.”

To do that, CIBC looked at three market measures that correlate with recessions: the yield curve (two-year and three-month U.S. Treasuries), the six-month change in the S&P 500 and the 10-year corporate spread—all lagged six months.

Taken as a whole, the measures indicate markets aren’t assuming a recession within the next half-year or so, Shenfeld said: “Equities have done too well, and corporate spreads are too narrow, to capture that sort of worry.”

With no recession built in to market expectations, escaping a recession won’t in itself be bullish for stocks, he added, especially since the bond market is pricing in some Fed rate cuts that would be of benefit to interest-rate sensitive equities.

Finally, he said that odds of a recession (assuming those odds could be effectively calculated) are likely lower than they were a couple of months ago, because U.S.-China trade talks seem to be making progress and global central banks are becoming less hawkish.

To that last point, past periods of yield curve inversion coincided with restrictive monetary policy, which doesn’t reflect the current situation in the U.S. or Canada, said a financial markets report from RBC. The federal funds rate is at the lower end of most neutral estimates, and the Bank of Canada’s overnight rate is below the central bank’s assumed 2.5%-3.5% neutral range.

Recent yield curve inversion instead reflects investor expectations for rate cuts by the central banks, the RBC report said. “A 25-basis-point fed funds cut is expected by the end of this year (compared with two hikes previously priced in), while odds are tilted toward a BoC cut (three hikes expected as of last October),” the report said.

Still, investors shouldn’t be dismissive of recession risk. At this late stage of the cycle, growth is more likely to surprise to the downside, RBC said.

Upside surprise isn’t off the table, though. In a weekly financial digest, BMO deputy chief economist Michael Gregory said the market plunge in December and bad winter weather have weighed on economic activity as businesses and consumers postponed purchases. Now that spring has sprung, a reversal could occur.

For example, December’s near-bear market “might go down in history as just a nasty correction—cue consumer and business confidence,” Gregory said. Further, the S&P 500 could be poised to “fully recover last year’s plummet and begin extending the bull market that has been in place since March 2009,” he said.

For full details, read the reports from CIBC, RBC and BMO.