16th January 2014
The US is at risk of entering a recession in 2015 according to James Abate, manager of the Psigma American fund. Abate stresses that this is not the majority scenario ‘but it is decent if not increasing one’.
He says that the risk arises particularly from the distorted interest environment and over-reliance on central bank policies.
“If you look at the typical period of time between recessions, historically it is usually around five to seven years. You will have heard some people talk about the fact that we are due for a recession.
“There is an increasing risk of recession in 2015 but not because of some clock that is going to go off. Whereas most recessions are caused by the Federal Reserve tightening monetary policy in response to growing inflation, my view is that the potential for a recession lies in the fact that we have created a very distorted interest rate environment. Ironically, what may be a catalyst for recession is potentially slower growth”.
Abate says that some of this is because of “the ageing demographic globally something that I continue to feel is unappreciated by most investors and most economists. What you have is essentially a very powerful deflationary impact with negative demographic trends around the world.”
He notes the impact of retiring baby boomers is only beginning.
The other issue facing the US is productivity. “There is no evident catalyst for productivity increasing. You have these very powerful deflationary forces, which because fiscal policy has essentially been removed from the equation, forces the central banks to be the end all to combat these deflationary forces.
He says the Fed is likely to stay aggressive, and look for other unconventional measures beyond the Federal Funds Rate, and bond purchases, but it may lose control of the “long end of the yield curve”.
He says: “There is a potential the Fed is overwhelmed by its belief that unemployment is too high and inflation is too low. They are pumping a lot of money into the system but the velocity of that money is at an historic low. From my perspective what would cause a recession in 2015, unlike the traditional history of the Fed raising its policy rate and tightening credit and flattening the yield curve, is essentially the Fed engineering through some unconventional measures, a higher level of inflation into the economy to offset the deflationary impact of poor demographics and lack of increase in productivity. This essentially boils down to the Federal Reserve losing control over the long end of the curve meaning a rapid rise in the long term interest rates even though short term interest rates stay essentially at zero”.
Abate points out that a very small increase in long term interest rates, has already had a profound and negative impact on housing and other sources of consumer finance in the US.
“If that occurs regardless of what the policy rate is, it could stay at zero, but if the Fed loses control over the long end of the curve because of inflation expectations that could be the catalyst to push the economy into recession.”
He says that the US could try and ward off a recession with very pro-growth fiscal policies.
The traditional way to extend this business cycle would be to introduce very favourable tax reform particularly to capital investment say an investment tax credit. But he notes that some of the temporary measures that were put in place are expiring.
He suggests that Barack Obama is a weakened President, disliked by Democrats as well as Republicans
“It is very unlikely that anything bold to offset the monopoly that the monetary policy has is on the horizon. If we start to go down that road, the ability to mitigate that through some other policies, namely fiscal policy is simply not there.”
In terms of investing, Abate says that he still expects a modestly improving growth outlook for operating profits through early 2014.
“We do not foresee the cost of capital declining as was the case in 2013 and, more importantly due to high valuation levels, investor confidence is likely to erode as the improving tone of economic growth falters and companies as a whole disappoint in terms of lofty profit expectations as the year progresses.
The “goldilocks” environment of two percent growth with no inflation will continue for the very near-term, but we expect increasing concern as the year progresses and we think higher inflation in 2014 and a recession in 2015 is a growing possibility.
“It is important to be mindful of the macro backdrop given its significance on day-to-day market fluctuations. At present, in the absence of any one sector of the stock market being uniformly inexpensive with improving fundamentals, the best strategy is to focus on those individual companies whose profit growth and efficiencies will increasingly stand out as the business cycle matures further.”
He also provides a view on the stocks which should continue to do well.
The note adds: “These stocks should distinguish themselves from the broad market through organic growth from innovation, pricing power and their global reach. US companies such as Google, Johnson & Johnson, UPS, Schlumberger, Procter & Gamble, BlackRock, Starbucks, PepsiCo, Verizon, Citigroup, and Coca-Cola all exhibit these attributes.
“Combined with this portfolio component in a barbell approach, there remain selective companies in the US that continue to harvest growth in earnings and continue to enhance operations by streamlining labour forces and optimising assets. Namely US companies such as Tyco International, Lam Research, SanDisk, Avon Products, Urban Outfitters, Juniper Networks, Boston Scientific, NVidia, Sealed Air, Noble Corp., Express Scripts, Cardinal Health, EOG Resources, HCA, Calpine, Cardinal Health, Network Appliance, Paccar, Microchip, and Devon Energy.”