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Market Outlook 2020: GDP & Recessions
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Real gross domestic product (GDP) is a measure of the total production of goods and services in the economy. Real GDP in the U.S. has averaged 3.8% over the last 230 years (1790 to 2019). At that rate of growth, the size of the U.S. economy’s production was, in effect, doubling every 18 years. When growth like this occurs, the average material standard of living increases for the U.S. population. Unfortunately, the 1960s was the last decade where real GDP exceeded 3.8%.

From 1970 to 2019, the average growth rate has diminished to 2.76% and since the financial crisis (2008), the average growth rate has dropped to 1.85%. The U.S. economy will need to return to above a 3.0% average so the Federal Reserve (Fed) will have the flexibility to reduce its balance sheets (raise rates) and in order for Congress to have the flexibility to address the national debt through a fiscal policy mix (reduced spending and higher revenues). The top personal income tax rate has been cut six times since 1980. During the 10 years that followed the Tax Reform Act of 1986, U.S. GDP averaged 3.0% a year.

Fig 1. Real GDP Decade Average & Rank (1790—2010) Fig1-MarketOutlookPart1.jpg
Source: Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis, Calculated by Arrow.

The tax cuts ushered in by President Donald Trump’s administration have boosted GDP growth 2.52% from 2017 to 2019. To put that into perspective, during President Barack Obama’s tenure, the average GDP was 1.59%.

We are 10.7 years into the economic expansion. In 2019, the Fed returned to its accommodative monetary policy, lowering rates. Each move pushed the markets closer toward a downward-sloping yield curve. During the course of 2019, the yield curve inverted slightly with 10-year rates dropping 48% from the 3.15% high in October 2018.

Fig 1a. Real GDP Growth by President Fig1a-MarketOutlookPart1.jpg
Source: Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis, Calculated by Arrow.

This was the first time the yield curve inverted since 2006. Toward the end of 2019, the yields on the 10-year Treasury were on the rise with a 14% increase since Aug. 2019. Stock markets don’t perform well after short-term rates exceed long-term rates because historically, when this happens, the U.S. economy falls into a recession a year after an inversion. Investors should anticipate a gradual increase in long-term rates in 2020. Hedging portfolios from an increase in long-term rates should be a common theme, especially when rates are well below their long-term mean average. If short-term and long-term rates rise, yield spreads will flatten and then reinvert. This would most likely be a precursor to a U.S. recession and what should follow is another spike in the yield curve.

While Wall Street closely watches the spread between the long-term and short-team rates, a better measure may be to look at the three-year average of the yield curve spread.

Fig 2. Yield Curve Ratio vs. GDP
Source: Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis, Calculated by Arrow.

Typically, when the yield curve spread falls below .50, GDP declines and the economy falls into a recession. Since 1979, when the .50 threshold has been crossed, a recession has begun on average within 191 days. Once that cycle has started, the U.S. economy has taken 182 to 517 days before the start of the next expansionary period. We anticipate the yield curve ratio to fall through the .50 threshold at the end of the second quarter of 2020.

The current economic expansion stands at 128 months. The average expansion since 1929 is 62 months. With tax cuts in place, a strong demand for labor, firm household discretionary spending and capital spending plans in the works, there is a high probability that this expansion will continue. Unfortunately, the expansion that started in June of 2009 has been 2.3% annually, which is the weakest real GDP growth among the 14 expansion periods that have occurred since 1927.

Investors should remember that the stock market cycle is not the same as the economic cycle. Typically, the stock market peaks nine months prior to the economic cycle peak. All of these factors should compel investors to invest more prudently in 2020 by designing a portfolio with greater concentrations in:
  • Higher quality securities
  • Fixed income products that can be responsive to interest rate changes
  • Diversified equity market exposure outside the U.S.
  • Alternative investment strategies that will help preserve capital

  • Fig 3. Business Cycle-Expansion in Months
    Source: Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis, Calculated by Arrow.


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