To my clients:

It was a mixed week for North American stock markets with the Canadian TSX finishing up 1.3%; the U.S. Dow Jones Index finishing down 0.9%; and the U.S. S&P 500 finishing down 0.3%.

Inspired by concerns of increased interest rates and related policies by the U.S. Federal Reserve, volatility has prevailed in stock markets the first two weeks of 2022. Unsurprisingly, I’ve begun receiving calls from a handful of clients wondering whether they should be concerned about this short term weakness. Simply put, my answer has been “No”. I supported this opinion by noting a) that the sharp drop in markets to begin 2022 has merely offset the positive gains seen by most clients in the last quarter of 2021; b) that corrections of ~ 10% or more are a regular phenomenon of stock investing occurring, on average, once per year (I should also note that broad market declines are nowhere near 10% as yet); and c) recession is nowhere in sight. Let’s spend the rest of this week’s update on “c”.

As clients well know, my and RBC’s long standing mantra has been that equities (i.e. stocks) should be given the benefit of the doubt at ALL times except when there is a credible threat of recession. All other market volatility and corrections occurring outside of the credible threat of recession should be ignored. Why? Because it is simply impossible to successfully and consistently time these “regularly inconsistent” (seeming paradox intended!) episodes in the market. Taking aggressive defensive measures at such times will, more often than not, result in a client being whipsawed out of some portion of their otherwise sound equity portfolio. Attempts to buy back what was sold will, again more often than not, be done at prices higher than received when selling. In other words, long-term returns will be lessened.

So if recession is the bogey we are trying to avoid, why do I say with confidence that recession is nowhere in sight? To answer, I’ll first observe that recessions were a more regular economic phenomenon for prior generations. For many of us when we were younger or, perhaps, for our parents and grandparent, we recall a time when recession occurred every 4 or 5 years. However, as economies have advanced and, more to the point, central banks (such as the U.S. Federal Reserve, the Bank of Canada and the European Central bank etc.) have learned to fine tune monetary policies, recessions have become less frequent. Recessions now appear, on average, to be a once a decade phenomenon. I point this out because the last, covid induced, recession occurred less than 2 years ago. It would be statistically improbable for another recession to occur so soon after. But beyond statistical probabilities, let’s look at what actual indicators of recession are portending…

I’ve written before that RBC maintains a 6-point “scorecard” for recession probabilities. In recent weeks, this 6-point scorecard has been updated to include a 7th indicator of recession. Each of these indicators is assigned a value of “GREEN” (conditions are indicative of economic expansion), “YELLOW” (caution might be warranted) or “RED” (conditions are indicative of recession). Historically – even when recession is unlikely - it has been rare for all scorecard indicators to be unanimously green or red. Even when conditions are generally strong, because economic forecasting can be messy, there is usually some segment of the economy that might, at least, be flashing a warning sign. However, at present, all seven of RBC’s recession indicators are flashing green. In other words, no recession is in sight. Many clients can stop reading at this point since the take away message has been established. However, for those who like details (and I know there are some in the audience), let’s quickly look at the 7 indicators:

1) Yield Curve inversion – the granddaddy of all recessionary indicators. When short-term interest rates move higher than long-term rates, this is a classic predictor of recession with an exceptional track record. Short-term rates are presently lower than long-term rates. Signal: GREEN

2) Unemployment Claims – As I’ve written regularly in the past, perhaps RBC favourite recessionary indicator. A bottoming of unemployment claims has consistently and reliably preceded the arrival of a U.S. recession, with the cycle low typically occurring three to four quarters before the recession’s onset. Currently, the smoothed trend of weekly claims continues to move lower. Signal: GREEN

3) Unemployment Rate – Similar to jobless claims, when the unemployment rate turns the corner and begins to rise, this is a reliable indicator of recession. The unemployment rate just hit a new low for this cycle. Signal: GREEN

4) Conference Board Leading Indicators (LEI) – As the name suggests, a composite of 10 leading indicators of recession (two of which, unemployment claims and the yield curve are included in RBC’s own recession scorecard… so yes, there is a small degree of double counting here). Whenever the LEI reading has moved lower than where it was 12 months prior, a recessions has ALWAYS followed. Current readings are 8% higher than last year. Signal: GREEN

5) ISM New Orders Minus Inventories - The difference between the New Orders component and the Inventories component of the ISM Manufacturing Index has fallen below zero near the start of most U.S. recessions. This particular indicator has delivered some “false positives” in the past, so it shoukd be viewed as more of a corroborative indicator rather than predictive indicator. The spread between new orders and inventories has narrowed from its post-pandemic peak of a few months ago but remains well above zero. Signal: GREEN

6) Fed Funds Rate vs Nominal GDP Growth – a measure of how “easy” money is to obtain. The exceptional covid recession notwithstanding, since the Federal Funds rate was established in the 1950’s, there has NEVER been a case of recession that was not preceded by the Fed Funds rate rising higher than the nominal growth rate of the economy. The current differential between the “nominal” (i.e. including inflation) economic growth rate of 9% and the Fed Funds rate of ~ 0.1% is a historically staggering 8.9%. While this indicator occasional delivers “false positives”, it is nonetheless the case that a negative differential is a necessary precondition for recession and therefore, like the ISM New Orders Minus Inventories indicator in #5 above, this indicator is more useful as a corroborator of recession expectations as opposed to being strongly predictive. Signal: GREEN

7) ***Free Cash Flow of Non-Financial Corporate Business – the new indicator added to RBC’s recessionary scorecard. This measures the cash generated by non-financial corporate business as a percentage of GDP and is a recessionary indicator when the measure turns negative. It has only given one false positive in 65 years of data. Today, cash flows are growing far faster than the economy and not expected to weaken anytime soon. Signal: GREEN

Again, I reiterate, even when the economy is expanding and we at RBC are confident that no recession is imminent, it is rare that we find all of our indicators to be unanimously pointing in the same direction. Now is one of those rare times. The Fed inspired volatility of recent weeks shall pass. Recession is not imminent and equities should be given the benefit of the doubt.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Senior Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
Toll Free: 1.844.665.9900 │Email: nick.scholte@rbc.com

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