JPM: "Everyone Is Asking The Same Question"

In a note from JPM's chief cross-asset analyst John Normand, the bank's strategist writes that in conversations with clients, "everyone is asking the same question" - namely 'where are we in the cycle?' and, Normand adds, with good reason: after all, the current US expansion is almost the second-oldest of the post-war era, and most investors are aware that "asset class, sector and style performance vary considerably over the cycle."

Normand admits that "answering this question around the economy's position is challenging, because the lifespan of US expansions has been quite variable (as short as one year or as long as ten) and because there is no standard definition of early, mid and late-cycle phases to complement the National Bureau of Economic Research’s (NBER) designation of recessions." Furthermore, JPM adds that "most equity and fixed income markets are expensive on standard metrics, offering little risk premium for a possible slowdown as rates rise over the next two years, much less a more extreme outcome like recession."

In this context it is not surprising that the same question draws three vastly different answers from three different banks.

Logically, first there is JPMorgan, which while noting that markets may be in the "twilight of the mid cycle" and investors should be prepared to sell stocks if the economy edges toward a recession, there is still time. That's because according to the bank's proprietary model, the odds of a recession in the next year are a relatively modest 18%, rising to 52% over 2 years, and a more troubling 72% over three years.

What does the above chart imply? To maximize absolute returns, JPM says that those who prefer to be early for the next recession, perhaps due to liquidity considerations, should position when 2Y or 3Y odds are at least 70%. Those who prefer to remain invested until later in the cycle should reallocate when 1Y odds rise above 30%.

Traders should follow this model closely JPM contends, and writes that it would reduce its recommended cyclical exposure - long stocks, short bonds and credit - progressively "over the next year when one or several conditions have been met, like equities reaching our anticipated cyclical high of 3,000 on the S&P 500, or U.S. money markets pricing more of our base case of four hikes each in 2018 and 2019."

However, as the next chart shows, JPM's estimates that markets continue to exhibit mid-market positioning:

Equities, for example, have been delivering above-average returns and outperforming all other asset classes, while Bonds are delivering their lowest returns of the cycle and are underperforming most other asset classes. Within Equities, Cyclicals have been outperforming Defensives. EM bonds, stocks and currencies generally have outperformed DM assets. Credit returns have roughly matched Bond returns, meaning spreads have stopped tightening such that most of the return is from duration. Commodity momentum has not yet gone hyperbolic, and Energy and Base Metals are leading Precious Metals.


That's good news, as shifting into late cycle presents investors with a difficult dilemma: sell early and potentially lose on substantial upside before the drop, or stay too long and risk even more.

Positioning too soon before a recession invites underperformance in the last year or two of the expansion when Equities may continue to rise, even if the investor will be properly positioned when markets peak, volatility rises and liquidity becomes more challenging. Positioning too late in the cycle spares investors the discomfort of underperforming peers but also tends to expose the portfolio to higher volatility than other active strategies when the economy succumbs, since valuations would be higher and positioning more extreme by then.

And while the odds of a recession in 3 years are rising, and those who wish to exit well before the recession strikes may want to do so now, JPMorgan is still not in that camp yet, nor are most investors and hedgers. Furthermore, "a year or more of underperformance would not be credible with many even if eventually proven correct,” Normand writes and adds that "from a systematic perspective we will await confirmation from the one-year signal before turning defensive on risk assets ahead of the first recession in a decade."

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Recession timers will be even happier with a similar exercise done by Goldman Sachs earlier in the week.

As Goldman's chief economist Jan Hatzius wrote over the weekend, "our cross-country recession risk model continues to put the odds of a US recession around 20% on a two-year horizon (Exhibit 1), implying that the current expansion—now just a couple months from becoming the second longest in US history—will more likely than not become the longest. And our US recession risk dashboard—a collection of the most valuable leading indicators drawn from both our research and academic studies—also sends a reassuring message."

In short, neither JPM nor Goldman would advise their clients to sell just based on traditional recession timing indicators.

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Of course, one would be forgiven to be cynical here and recall that both Goldman and JPM are heavily invested in perpetuating a non-recessionary cycle, and even more heavily conflicted in keeping clients actively trading, not merely selling and cashing out.

Which is why we remind readers that a third, perhaps far more accurate forecast of recession odds shows something vastly different. As we presented over a month ago, Private Equity firm KKR, which is certainly far less conflicted on a client relationship basis - as it does not generate revenue from active trading - had a very different recession forecast.

On one hands, the near-term appears safe: KKR wrote that with tax cuts taking effect in 2018, the chance of a near-term recession appears quite remote. It added that "consistent with this viewpoint, our proprietary recession model, which we show in Exhibit 64, suggests a limited chance of recession during the next 12 months. According to the model, high interest coverage, tight High Yield spreads, low delinquencies, and a modest consumer obligations ratio all appear to be favorable tailwinds that should sustain economic growth through 2018."

To be sure, the 1 year recession probability is almost identical with both JPM's and Goldman's. However, when extending the forecast period to 2 years, something surprising emerges:

Interestingly though, when we extend the model from 0-12 months to 24 months, the risk of recession increases materially. One can see this in Exhibit 65. We link the uptick in the model’s cautionary outlook in late 2019 and beyond to a structurally peaking U.S. dollar, a flattening yield curve, higher unit labor costs, and some reversion to the mean in both consumer confidence and home building expectations.

And here is how KKR shows a virtual certainty of a recession in just 2 years.

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So going back to the original question which "everyone is asking", i.e., where are we in the cycle, it appears that the question will continue being asked, for the simple reason that - when stripped of bias and conflicts of interest - nobody really knows, and certainly not Trump's new top economist Larry Kudlow, who as a reminder back in December 2007 said there was "no recession" as "the Bush boom continued", and added that "the pessimistas are a persistent bunch."

Later, the NBER would determine that that was the month the recession had begun.