Is a Recession Imminent?

Why Investors Should Not Fear… For Now.

2016

Author: Ryan Hanna, CFA, CAIA

Title: Senior Vice President

Author: Catherine Hickey

Title: Vice President

Author: T.J Kistner, CFA, CAIA

Title: Director

Company: Segal Marco Advisors Website: www.segalmarco.com

Contents

Overview 1

Are We Close to a Recession Now?

How Can We Tell? 4

Indicator 1: Real Income 4

Indicator 2: Employment 8

Indicator 3: Wholesale Retail Sales 10

Indicator 4: Industrial Production 11

Indicator 5: Real GDP 12

Conclusion 15

This report was prepared by The Marco Consulting Group prior to its acquisition by Segal Rogerscasey. The combined firm is called Segal Marco Advisors.

2

Overview

US stock investors have become accustomed

to steady, strong returns over the last few

years, but a recent bout of lackluster perfor-

mance has caused many to worry. After seven

years of a bull market that began in 2009, the

S&P 500 was down -5.1% in the first two

months of this year. Since then, a robust rally

for stocks in March 2016 has eased investors’

pain somewhat. However, such sudden declines

for stocks may conjure memories of the 2008

financial crisis and the ensuing severe downturn

for stocks back then.

It was not just the performance declines that

sparked investor nervousness recently. The vol-

atility associated with these performance chang-

Source: FactSet

FIGURE 1:

Performance

Figure 1 depicts the performance of the S&P 500 index from 1996. The current bull market

for stocks began in March 2009 and has continued ever since.

3

es has also taken investors on a bumpier ride

than they have grown used to in recent years.

Volatility was relatively low between 2012 and

2014, as news about the economy improved stead-

ily and investor optimism grew. However, choppi-

ness has returned in 2015 and early 2016 and

comes on the heels of a disappointing 2015 for

stocks, commodities, and many bond categories.

Volatility, which is indicated in Figure 2, is back

in part because investor nervousness about the

economy has grown recently.

As concern has grown regarding the health of the

U.S. economy, chatter on financial news outlets

has turned to the possibility that a recession could

be imminent. An economic recession has direct

impact on the performance of the assets in your

Source: FactSet

FIGURE 2: Volatility

Figure 2 depicts the level of volatility of S&P 500 stocks. Volatility was relatively high during

and in the years after 2008, but it dropped significantly from 2013 to 2015. It picked up again in

late 2015 and early 2016, as worries about the global economy made investors nervous.

4

portfolio. In a recession, investment assets typically

perform poorly as conditions make it more difficult

for businesses to grow, workers to find jobs, and

consumers to spend. Thus, while recession is an

economic phenomenon, it has real consequences

for markets and for portfolios.

As typically defined by mainstream media, a reces-

sion is identified by two consecutive quarters of nega-

tive Gross Domestic Product (GDP) growth. However,

there is a more granular definition which is defined by

the National Bureau of Economic Research (NBER),

which states a recession is a significant decline in

economic activity spread across the economy, lasting

more than a few months.

The NBER says that in a recession, declines are nor-

mally visible in five primary indicators including:

Real Income

Employment

Wholesale-Retail Sales

Industrial Production

Real GDP

Three of the five indicators (real income, employment,

and wholesale-retail sales) are directly related to the

health of the consumer, which accounts for 2/3 of the

U.S. economy. This paper will examine the state of

each of these economic indicators and how that re-

lates to prior economic cycles.

So, Are We Close to a Recession

Now? How Can We Tell?

Indicator 1: Real Income Real income, or real disposable income, is a proxy

for consumers’ ability to spend money. It is an in-

flation-adjusted metric for how much money con-

sumers have to spend on things other than essen-

tials such as food and utilities. The more disposa-

ble income consumers have, the more likely they

are to buy cars, houses, boats, etc., which in turn

stimulates the economy.

Figure 3 shows real disposable income (in $)

over time, as well as the rate of growth. As men-

tioned previously, consumption (the consumer)

accounts for 2/3 of GDP in the U.S. Figure 3

indicates that sharp drops in disposable income

often precede a recessionary period as consum-

ers are less likely to spend. In examining the

current environment, real disposable income

looks strong (up 3.4% in 2015) likely due to the

sharp drop in oil prices. In essence, this trans-

lates into savings at the pump for consumers

and more money that can be spent on other discre-

tionary items. While the US experienced a sharp drop

5

in disposable income in 2013, the economy was able

to avoid recession and rebound the following year.

The outlook for income growth is still very strong,

though there was a leveling off in real disposable

income late in 2015.

Another important data point that impacts real

income for consumers is the unemployment rate

and wage growth. Simply put, as more people

work and their pay increases, they have more

discretionary income that can be spent to stimu-

late the economy.

Source: FactSet

FIGURE 3: Real Disposable Income

Figure 3 depicts the past two recessions have been preceded by a decline in Real

Disposable Income. Real Disposable Income has continued to show strength over the last

few years.

6

Figure 4 shows unemployment continues to

drop steadily and currently sits at 4.9% as of

the end of February, roughly in-line with pre-

Financial Crisis numbers. Wage growth is also

starting to increase, an indication that dispos-

able income is increasing as well.

Another encouraging sign for income growth is the

quit rate in the U.S. Quit rates and wage growth

are positively correlated, meaning as quit rates

increase, wage growth increases as well. People

typically quit their job in order to pursue a higher-

paying job, so a higher quit rate could translate to

more higher-paying jobs.

Source: FactSet

FIGURE 4: US Unemployment and Hourly Earnings Growth

Figure 4 depicts recessionary periods are typically accompanied by increasing unemployment

and declining wage growth. Unemployment rates have been declining for the past five years

while wages are improving.

7

You will notice in Figure 5 that leading into and

throughout a recession, employees are less likely to

quit their job since as there are fewer jobs to find as

many workers have been laid off. The current level of

quits in the U.S. is strong and may indicate further

income growth for the consumer.

Declining Improving

Indicator Rate: Real Income

An improving labor market should lead to

improving wage growth.

Source: FactSet

FIGURE 5: Quits and Wage Increases

Figure 5 depicts quit rates and wages generally decrease during recessionary periods.

Currently, quit rates and wages are increasing.

8

Indicator 2: Employment Employment is another key metric for the consum-

er. The more people employed in an economy, the

higher the output and the more money that can be

spent within the economy. Figure 4 showed the

strength in the unemployment number, which cur-

rently sits at 4.9%. Another indicator for strength in

the job market is the Weekly Jobless Claims. Fig-

ure 6 shows that jobless claims are at the lowest

level in 16 years, indicating that fewer and fewer

people are filing for unemployment benefits. Mean-

while, the number of nonfarm hires in the U.S. is

back to pre-Financial Crisis levels. Both of these

metrics indicate a healthy labor market.

Figure 5 highlighted the relationship between quit

rates and wage growth. Figure 7 shows that while

the number of quits in the U.S. is increasing, the

Source: FactSet

FIGURE 6: Weekly Job Claims and Hires

Figure 6 depicts hires decrease and jobless claims increase during recessions.

Currently, hires are increasing while jobless claims are decreasing.

9

number of job openings is also increasing and at a

greater rate. This indicates that as people search

for higher-paying opportunities, there are more

jobs available for them to find. Typically, in pre-

recessionary periods you would see the job market

dry up and the number of job openings fall as com-

panies cut work forces to prepare for earnings

slumps. This is not happening within the current

job market environment.

Declining Improving

Indicator Rate: Employment

Unemployment rate is steadily declining while

job openings remain plentiful.

Source: FactSet

FIGURE 7: Quits and Job Openings

Figure 7 depicts job openings and quits decrease during recessions. Currently, job

openings and quits are increasing.

10

Indicator 3: Wholesale Retail Sales Retail sales growth, another measure of the

strength of the consumer, has been strong since

2010. This metric is tied very closely to income

growth. As mentioned previously, the more dispos-

able income a consumer has, the more likely that

consumer is to buy things such as cars, applianc-

es, homes, etc. Weakness in retail sales can often

be a sign of bad things to come for the economy,

as Figure 8 highlights.

Source: FactSet

FIGURE 8 Retail and Auto Sales

Figure 8 depicts retail sales have decreased during the past two recessions.

Currently, retail sales are increasing which proves contrary to past trends.

If consumers lose their job or are becoming wor-

ried they might lose their job, the likelihood they

are going to spend money on big ticket items is

low. You will notice the sharp drop in both retail

sales and vehicle sales during the Financial Crisis.

Compare that to today’s environment, and the

economy has been experiencing strong (albeit

slowing) retail sales growth and even stronger

growth in larger purchases such as vehicles. Vehi-

cle sales are back to or above pre-Financial Crisis

11

levels, indicating consumer confidence in the job

market and a willingness to spend money.

Declining Improving

Indicator Rate: Wholesale Retail Sales

Retail sales growing though at a slower pace.

Indicator 4: Industrial Production Industrial Production has been the weakest com-

ponent of GDP over the past couple of years.

While there are many factors at play here, two pre-

vailing themes have impacted this component

more than anything else since 2013. Those themes

are the strong U.S. dollar and energy.

Net exports/imports is the proxy for Industrial Pro-

duction within the GDP components. When this

Source: FactSet

FIGURE 9 Purchasing Managers Index

Figure 9 depicts manufacturing and services both slow materially during recessionary periods.

Manufacturing is in correction territory while services is still in expansion, though weakening

12

number is negative, the U.S. is importing (buying)

more goods than it is exporting (selling). Over the

last couple of years, the U.S. dollar has significantly

appreciated relative to virtually every other major

currency in the world. This makes U.S. goods more

expensive to foreign buyers, therefore encouraging

those buyers to purchase from another country. This

dynamic is hurting exports, and as a result, the

industrial sector as a whole.

Figure 9 shows the Institute for Supply Manage-

ment’s Purchasing Managers Index both for the

manufacturing and non-manufacturing (services)

sectors. A reading above 50 indicates expansion

within that industry and a reading below 50 indi-

cates contraction. As shown in the chart, manufac-

turing has recently entered into “contraction” territo-

ry. While this may be cause for concern, the manu-

facturing sector only accounts for roughly 12% of

the U.S. economy.* The services sector, which

accounts for two-thirds of the economy’s produc-

tion, is still in “expansion” territory.

Another theme impacting Industrial Production is

energy. Oil prices have fallen from around $110/

barrel in 2013 to as low as $26/barrel in 2016 on

the back of dramatic supply increases and con-

cerns over slowing global growth. This prolonged

price correction has inflicted extreme stress on oil

companies and all other related businesses and

financiers. In turn, these oil and energy companies

have been slashing capital expenditure budgets

and postponing (or cancelling altogether) invest-

ments in new projects. This reduction in investment

also flows through to the “Gross Private Domestic

Investment” component of GDP and is a large rea-

son for the weakness.

Indicator 5: Real GDP GDP in the U.S. is comprised of four primary

components: Gross Private Domestic Invest-

ment, Personal Consumption Expenditures, Gov-

ernment Consumption Expenditures & Gross

Investment, and Net Exports of Goods and Ser-

vices. By far, the largest component of GDP is

Personal Consumption Expenditures (the con-

sumer) which accounts for nearly 2/3 of GDP.

Figure 9 highlights GDP growth over time along

with each individual component’s contribution to

GDP growth. A couple of observations can be

Declining Improving

Indicator Rate: Industrial Production

Strong dollar and weakness in energy is

hurting industrial production.

*source: http://www.businessinsider.com/manufacturing-vs-service-sector-divide-2015-11

13

Source: FactSet

FIGURE 10: Components of GCP Growth

Figure 10 depicts personal consumption and business investment weaken or turn negative dur-

ing recessions. Currently personal consumption is positive, but shrinking while business invest-

ment is flat to negative.

made leading up to and entering into a reces-

sionary period (the dark shaded area). First,

strength in the consumer (yellow bar), the larg-

est component of GDP, begins to weaken and

may even turn negative. Often times this will be

the result of a weakening labor market or gen-

eral loss of confidence consumers have in the

economy. The second observation has to do with

Gross Private Domestic Investment (green bar).

This too will often weaken or turn negative lead-

ing up to a recession. This is a reflection of busi-

ness growth and corporate strength within the

economy. When corporate investment dries up,

companies begin to lay off people and earnings

typically suffer.

14

Leading into the recession of 2001, consumption and

domestic investment numbers were strong. In mid to

late 2000, these numbers began to weaken or drop

off altogether. This coincided with the infamous Tech

Bubble, a period when “dot com” or other tech stocks

were trading at valuations never seen before and

certainly not warranted by the cash flows these busi-

nesses were generating. Once the market crashed

and many of these tech companies went bankrupt,

business investment dropped off, workers were laid

off, and the consumer stopped spending money on

discretionary items.

A similar dynamic played out leading up to the Fi-

nancial Crisis in 2008-2009. This time around, the

bubble resided in the housing market. Sub-prime

mortgages, or mortgages given to less credit-

worthy borrowers, were growing at an alarming

rate as more and more Americans wanted to own a

home amid the rapid increase in home values in

the mid-2000s. Banks were happy to lend to these

borrowers, package the mortgages in a collateral-

ized pool, and sell those packages as investment

products to the general public. All of this activity

was additive to business investment and consump-

tion in the early to mid-2000s. Once home prices

began to fall and these sub-prime borrowers de-

faulted on their mortgage payments, the wheels

were set in motion for a broad collapse in the econ-

omy. Banks took large losses on the mortgages

they owned and would no longer lend money to

businesses, who in turn laid off millions of Ameri-

cans, who in turn curtailed spending.

In comparing these two periods to the current eco-

nomic backdrop in the U.S., the largest component of

the economy (the consumer) appears to be very

strong. More importantly, the data supports the notion

that the consumer continues to remain relatively

healthy. Disposable income is rising while unemploy-

ment is falling, job openings are plentiful while the

number of people filing for unemployment is at multi-

decade lows, and consumers are spending the mon-

ey they are saving at the pump due to lower oil prices.

The one blemish in growth continues to be in the

Manufacturing sector due to the strength of the U.S.

Dollar and the impact low oil prices have had on in-

vestment within the energy sector.

Declining Improving

Indicator Rate: Real GDP

GDP growth positive but still low.

15

Conclusion:

This analysis of economic data is not meant to be

exhaustive. It is nearly impossible to be able to pin-

point the time when an economy enters recession,

and just because these indicators do not demon-

strate one now does not mean that a recession is not

here or is not coming.

Some spots in the economy are still stronger than

others, while some, like industrial production, have

shown continued weakness. For instance, factory

orders, an indicator of industrial production which

tracks output in the economy, was negative in 2015.

This has, at times, led to the economy entering into

recession in prior economic cycles.

Nevertheless, the data in this analysis of NBER re-

cession indicators does not appear to show that the

U.S. is currently in a recession or imminently heading

into a recession. Instead, the economy seems rela-

tively healthy enough to continue to grow, albeit at a

lower rate than in the past.

Given all this information, what should investors do?

Though it’s tempting to make changes based on the

economic tea leaves, for the most part investors

should stay the course. It is important to stick with

your asset allocation through times of uncertainty.

During volatile times, a diversified asset mix can be

the best way to weather the storm. Different assets

perform well at different times, and when stocks sink,

assets such as high-quality bonds can perform better.

It is always important to reconfirm your financial road

map for achieving your investment objectives, espe-

cially during times of volatility. However, investors

would do well to sit tight and ride out any market un-

certainty knowing investment objectives are generally

achieved over long periods of time.

Declining Improving

Indicator Rate: Real Income

Declining Improving

Indicator Rate: Employment

Declining Improving

Indicator Rate: Wholesale Retail Sales

Declining Improving

Indicator Rate: Real GDP

Declining Improving

Indicator Rate: Industrial Production

The views contained in this report are those of The Marco Consulting Group (MCG) and are based on information obtained by MCG from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular investment product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from The Marco Consulting Group.