A long road to recovery has investors wondering if the end is nigh

However, the recovery’s been going on for so long, that many investors are wondering if the end is nigh. This is now the second-longest period of growth in American history, having recently matched the expansion from 1961 to 1969, an era of big government spending under presidents John F. Kennedy and then Lyndon B. Johnson.

Unlike the rapid growth of the 1960s, the current expansion hasn’t been setting any records for its speed. It’s taken a long time for unemployment to get back to healthy levels and wages have only recently begun to accelerate ahead of the rate of inflation.

However, the tortoise-like nature of the recovery may help account for its longevity. The slow speed has prevented it from overheating. Despite three hikes already this year, official interest rates remain at just 2% to 2.25%. One early warning signal of an upcoming recession is a ‘flatter’ yield curve, as longer-dated government bond yields fall relative to shorter-dated yields in expectation that rising rates will lead to slowing growth and inflation down the track. Even though the curve has flattened recently, our analysis suggests that it’s indicating less than a 20% chance of a US recession in the next 12 months (figure 1). 

Meanwhile, some commentators are concerned about the weakness of copper prices along with other industrial metals. But they tend to fall during, rather than before, a recession, and these markets are vulnerable to lots of false signals.

Figure 1: Forecasting a slowdown

_{The shape of the US yield curve can be seen as an indicator of the risk that a recession is coming, but it's not flashing red at the} ^moment.

^{_{Source: Bloomberg, Rathbones}}

Slow and steady

We don’t see a recession on the near horizon, meaning the recovery could persist beyond July 2019, when it would surpass the 1991 to 2001 expansion as the longest on record. Our analysis of the economic environment suggests this is more likely than not.

Our global leading economic indicator (LEI) has recently rolled over, with the annual rate of change turning negative. This has been driven largely by the Asian and commodity-related components, and could be bad news for more cyclical markets. Yet it’s still signalling a decent amount of GDP growth. Some economists say that forecasting the business cycle is as easy as looking at the direction of monetary policy over the past two years. But this relationship hasn’t been strong over the past decade. We prefer to look at a combination of consumer interest rates. These do suggest economic activity is slowing, but it’s not yet clear if this is another mid-cycle slowdown or something more sinister.

Meanwhile, despite some recent hand-wringing headlines to the contrary, the US housing market is buoyant. For example, new permits for building private homes are at a record high. Lumber prices have recently fallen sharply. However, they are only correcting an earlier spike related to President Donald Trump’s tariffs on Canadian imports and some unfortunately timed transportation problems north of the border. Prices for this house-building material remain a long way above the long-term average. 

Stock market concentration

The strength and dominance of the US economy, and its tech sector in particular, was amply illustrated in August when Apple became the first company in history to reach a market capitalisation of one trillion dollars, followed a month later by Amazon. 

Indeed, the five largest US technology stocks — Facebook, Apple, Amazon, Microsoft and Alphabet (Google’s parent) — now represent over 15% of the S&P 500 index. In July they had a combined market capitalisation of just over $4 trillion, equal to the S&P 500’s smallest 282 companies combined — and this huge list of the “smallest” includes many major household names such as Ralph Lauren, Kellogg’s, Goodyear Tires and Gap. Given their large size, what happens to these tech stocks has an outsized impact on the performance of the wider index.

A narrow focus

This concentration in the S&P 500 is not new— for example, for most of the 1960s, General Motors was the largest US company, representing 10% of the S&P 500 at times, compared with Apple today representing just 4.4%. The top five companies were 25% of the index through much of the 1960s. What is different this time is that the largest companies are now predominantly in one sector, technology, which adds to the perception that the S&P 500 (and by extension the US economy) is becoming too narrowly focused.

However, it appears that this situation is starting to change. The performance of the dominant tech stocks is starting to diverge (figure 2). So far in 2018 we’ve seen strong performance from Amazon, good performance from Apple and Microsoft, Alphabet performing slightly better than the S&P 500 Index and Facebook actually falling, as it faced the fallout from the Cambridge Analytica scandal. Investors are being reminded that the continued rise of the technology giants is not inexorable. 

Yes, they have significant positive network effects and deep competitive ‘moats’ by virtue of their large user bases (for example Facebook has 2.2 billion users across its social media platforms, while Alphabet has 1.8 billion users of its YouTube platform alone). They also generally have high profit margins, solid cash flow and strong balance sheets. But after some fairly hefty price gains, valuations in some cases are beginning to look expensive. Management teams are demonstrating that they can make mistakes. Importantly regulators are noting the network effects that these new ‘quasi-monopolies’ enjoy, and taking steps to curtail perceived market abuses. 

Figure 2: Tech's not the only thing going up

While the big tech stocks (FAANGs = Facebook, Amazon, Apple, Netflix and Alphabet) have led the S&P 500, the rest of the index has been performing reasonably well. 

Healthy divergence

This divergence of performance within the technology sector is healthy and, if it continues, will help investors to focus on interesting investment opportunities elsewhere. The S&P 500 beyond the dominant tech stocks has been performing pretty well, and this is important, as narrow performance is one of the signs that a bull market has peaked.

This breadth comes against the backdrop of a healthy outlook for the US economy, which continues to be vibrant and entrepreneurial, with high levels of innovation and strong business models leading to solid earnings growth and superior returns. To be sure, the debt levels of the median company are at all-time highs. We’re fairly relaxed about it, though, as companies have worked to extend the maturity of their debt and therefore are not too sensitive to interest rate rises. There are relatively few companies that are at risk of not being able to cover their debt payments. 

Active stock picking is key to identifying those companies with lower financial leverage, and with exposure to growing areas of the US domestic economy, particularly those likely to be insulated from the trade war with China.