Shouldn't We Have Had a Recession By Now?

Why we focus on adapting to long-term trends as opposed to predicting near-term events

Predicting near-term macro and market events has always been a difficult thing to consistently get right. And it is becoming even harder to do in a world where interventionist monetary and fiscal policy are becoming the norm. The failure of the inverted yield curve to presage a recession over the last two years is a good example of how previously reliable market signals are becoming less so in a world of significant government intervention. This is one of the reasons why predicting near-term macro and market events is not part of our investment process.

Instead, we focus on adapting client portfolios and asset class strategies to long-term trends. This doesn’t mean that we try to predict the emergence of social, economic, technological or geopolitical trends before anyone else. Rather, it means thinking about the impacts of prevailing long-term trends on our clients’ portfolios and our asset class strategies and positioning them to mitigate risks and participate in new opportunities. Today, and in the coming years, we believe powerful trends—like slowing globalization, the energy transition, greater market volatility, continued growth of private asset markets and generative AI—will continue to be things successful investors need to focus on to generate better long-term investment results.

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Shouldn’t we have had a recession by now?

Since 1976, the yield curve has been one of the most reliable predictors of recessions. Every time it has “inverted” (meaning those periods where yields on 2-year government bonds exceeded those of 10-year government bonds), a recession (as defined by the National Bureau of Economic Research) has followed within 24 months.

Is this time different? So far, it is certainly looking that way.

The US government bond yield curve inverted in July of 2022, which leaves just two more months for the economy to fall into recession and thus preserve this signal’s track record. That is now appearing unlikely as U.S. economic data is still positive (1.6% annualized in Q1 2024). Meanwhile, the U.S. unemployment rate has remained fairly steady and below 4% over the last two years

This is not “what is supposed” to happen when the yield curve inverts for such a long period of time.

A recession-defying economy

Current Real Rates

One potential explanation for why current rates have not led to a recession is that they have not actually been that high in real terms (defined as the U.S. Federal Reserve Bank’s policy rate less realized inflation).

Today, the Bank’s policy rate is 5.33%. That is about 185 bps above the current year-over-year headline inflation rate. That is high by recent standards. Between 2008 and 2020, the federal funds rate was on average 110 bps below year-over-year headline inflation on a monthly basis.

But, the current difference between the Bank’s policy rate and inflation is actually quite normal when one takes a longer-term perspective. Between 1960 and 2007, that spread over inflation was almost exactly where it is today, around 185 bps.

We have become accustomed to thinking that positive real interest rates are unusual. They are not. By historical standards, today’s real interest rates are almost exactly average.

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High Levels of Fiscal Stimulus

Another potential explanation for the ongoing strength of the U.S. economy in the face of higher interest rates may be the unusually high levels of government spending.

In 2023, the U.S. Federal Government deficit was 6.3% of GDP. That is bigger than any annual deficit in the post-World War II period, other than during the GFC and COVID-19 pandemic. The U.S. Federal Government is already spending as though it is trying to stimulate an economy in recession. In that context, the absence of a recession isn’t too surprising.

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Greater Government Involvement in Markets and the Economy

Since the GFC, “unconventional” monetary and fiscal policies have become much more common. Unconventional, it seems, has become the convention.

From 2009 to 2022, the U.S. Federal Reserve ran negative real policy rates in 12 of 14 years and provided significant support to markets by growing its balance sheet at an unprecedented rate from $475 Billion to $5.8 Trillion.?Both had profound impacts on investors.

Over that same time period, large government deficits also became the norm. Between the end of World War II and 2008, the largest U.S. Federal Government deficit ever run was approximately 6% of GDP, in 1983. Since 2009, the U.S. Government has run fiscal deficits in excess of 6% of GDP in 7 different years. And as described in more detail in our World View, we believe the propensity of the U.S. government to exert its influence in markets and the economy will continue. We are not alone in this view. In its April 2024 Fiscal Monitor, the IMF predicts that ongoing US fiscal support will continue and result in US debt levels (as a percentage of GDP) reaching World War II levels by 2030.

While governments are more likely to shape markets and the economy in the coming years, the specific ways they do so aren’t going to be easy to predict.

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Adapting Client Portfolios and Asset Class Strategies to Long Term Trends

Because predicting near-term market or macro events is a low-probability investment strategy, we focus instead on adapting client portfolios and our asset class strategies to long-term trends. This longer-term investment perspective is consistent with our overall approach to managing funds on behalf of our clients. Our World View identifies the long-term trends we believe will impact client returns the most over the coming decade. Here are a few examples:?

Declining globalization and higher, more volatile inflation

The decline of globalization is already leading to a greater risk of inflation than we have experienced over the last 30 years. Between 1992 and 2020, annual U.S. headline inflation ran above 3.5% only once. Yet inflation was above 3.5% in 2021, 2022, and 2023. This is why, for clients with inflation-linked liabilities, we have been recommending a better balance of both nominal and inflation linked bonds than they typically had in the past when deflation was viewed as the predominant risk.

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Energy transition

We believe that the energy transition is a real and very powerful long-term technological trend, where the levelized cost advantages of renewable technologies will lead to massive investments in new renewable power production and electricity transmission and distribution. According to Bloomberg NEF, global clean energy investment was $1.7 Trillion in 2023, up 17% from 2022 and over 700% from a decade ago. This technological development will create real risks for carbon-intensive assets and real opportunities for investors who can develop new renewable assets and own electricity transmission and distribution assets. This is why our infrastructure program is focused on these assets and why we have built teams with specialized expertise in this market segment.

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Heightened volatility and greater dispersion

We believe that the risk of higher inflation going forward will limit the ability of the Federal Reserve to reliably intervene to support markets during periods of volatility. The Federal Reserve will need to be more mindful of the risks of stoking inflation. Between 1974 and 2021, any time the S&P 500 declined by more than 12% on an annual basis, the Federal Reserve reduced its policy rate by at least 50bps. That was not true in 2022. The S&P 500 declined 19% and the Federal Reserve increased the policy rate by 425 bps. The “Fed put” that was so reliable until recently cannot be part of an investor’s strategy for managing market volatility. This is one of the reasons we are particularly careful right now to ensure that our clients have adequate access to high quality liquid assets so their portfolios can tolerate sustained periods of market volatility.

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Growth in private assets

We believe that the trend of growing private asset finance will continue. Together, Blackstone, Ares, Apollo, Carlyle, KKR and Brookfield, among the largest alternative asset managers, now manage approximately $4 Trillion. This continued growth will be driven by the advantages privately held companies often have over public companies in pursuing value enhancement strategies (an ability to focus on longer-term performance as opposed to quarterly results; less time spent on reporting; and more flexible capital structures). And this will be helped by financial regulations that are creating opportunities for business development companies and others to lend to companies that were previously dependent on bank or public bond finance. This is why we have continued to enhance our ability to invest directly alongside a core set of best-in-class private equity and debt partners.

Disruptive technologies

We believe that technologies like artificial intelligence (AI) will have a powerful impact on jobs, companies, and the economy, but that the specific winners and losers will be hard to predict in advance. As a result, we are “spreading our bets” and taking a “picks and shovels” approach to this trend. This means participating in the trend through our broad public market strategies which provide access to hyper-scalers, fast-growing companies like Nvidia and utilities (all of which have benefited from this trend) as well as infrastructure investments in data centres, fibre optics and utilities.

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Focused on the long-term

Generating investment returns by correctly predicting near-term economic and market events has always been difficult. Increasing government intervention and the evolving macroeconomic landscape has made it even harder. This is why we focus on adapting our client portfolios and asset class strategies to longer-term investment trends. We believe this is a much more reliable strategy that will lead to better investment results over the long term.