SINGAPORE (Dec 17): The signs are pointing towards a looming recession, but A J Kahling, senior manager of trader education and market strategy at online brokerage firm TD Ameritrade, believes investors can still find opportunities in the equities market in 2019.

It is not all doom and gloom, he says at The Edge Singapore’s 2018 year-end investment forum on Dec 8. “There is some probability of some kind of expansion in the overall economy [and] in the US economy.”

One of four speakers invited by The Edge Singapore to share their views on how to ride the disruption in the markets, Kahling notes that the US Federal Reserve is predicting only a 15% chance of a recession in 2019, although that is up from a probability of 9% a year ago. And he reckons that as long as the trade war is resolved by next year, a recession can be held at bay, at least over the next couple of months.

“If you ask us, we see some clouds on the horizon, but there’s nothing really imminent unless you look at the stock market and see this volatility. But most of that is just reverting to the mean after the uptick in 2017,” he explains. “The problem that we see right now is: How can we keep up this growth story?”

The way Kahling sees it, growth in the US had been driven by a loose Fed policy that kept interest rates at record lows, or quantitative easing, and corporate-friendly tax breaks. He explains that companies were flush with cash following the tax breaks, which led to many of them making a business decision to use that cash for stock buybacks. This then reduced the number of shares outstanding, which in turn increased the companies’ earnings per share figures. “In fact, in 2018, we were at an 18-year low for outstanding shares in the US markets,” Kahling says. But, he warns: “Those things are coming to an end.”

Now, he says investors should keep their eyes on two indicators that have been proven to herald recessions in the past.

The flipside of low unemployment

“We are currently near a 50-year low in unemployment. And you can say: ‘That’s great news! People have jobs, people are getting paid.’ Absolutely, I agree with you,” Kahling says. “The other side of that coin is that we’re running out of labour, skilled labour at that.” According to Kahling, more than half of the jobs created in the US in 2018 were for employees with less than a high school education. “Companies are now being forced to pay up to not only keep their employees but to hire new ones,” he says.

While that is good for employees, companies are going to see a squeeze on their profit margins. “This is more of a lagging indicator,” Kahling says (see Chart 1). “I’m not the biggest technical analyst, but you guys can see [that] every time when [the unemployment rate] gets down to the point where it’s at right now, it happens to shoot back up. And it almost always corresponds with a recession.”

https://s3-ap-southeast-1.amazonaws.com/tesuploads/861/1%20global%20slowdown.JPG

As Kahling explains, it costs more money for companies to keep employees and hire new ones as a market nears full employment. And some businesses are shutting down because of this.

“In the heartlands in Indiana, there are stories of some McDonald’s chains shutting down for a couple of hours a day because they don’t have enough employees. When this happens, the workforce starts asking for raises, starts asking for more money — as they should. Companies have to start paying up,” Kahling says. “Eventually, that catches up to the entire economy: inflation upticks, everything costs more, people stop spending as much, and that’s what triggers these recessions.”

Turning yield on its head

The other warning sign of an imminent recession is the inversion of the yield curve (see Chart 2).

https://s3-ap-southeast-1.amazonaws.com/tesuploads/861/1%20yield.JPG

“Six months ago, the yield curve was at 40 basis points. It’s now down to 11,” Kahling says, looking at the two-year yield against the 10-year yield. “Obviously, you should get paid more for tying your money up for 10 years versus two years. That’s normal; that should happen. But what’s happening is the gap between these is shrinking… Eventually, they will be even. Eventually, they could invert.”

Kahling explains that when the yield curve inverts, you get an abnormal situation where tying your money up for 10 years is not going to get you as much as if you had done it for two years. In essence, what this means is there is less predictive growth in the future.

“The reason why this matters is that nine out of the last nine recessions were preceded by a yield curve inversion. We’re at the point now; it’s very close to inverting again,” Kahling says. “It hasn’t yet, but it’s heading that way. It might not even have to invert. It might just flatten out and that could cause issues, and basically slow down global growth.”

While the two-year versus the five-year yield curve has already inverted, Kahling notes that this curve has resulted in more false positives than the two-year versus 10-year curve and the three-month versus 10-year curve. “What generally constitutes a full inversion is if all three of these yield curves actually do invert,” he says. “Keep your eyes on that yield curve. When that thing inverts, start the stopwatch and see how long we go before we see a recession [starting].”

But, to allay the fears of investors, Kahling says that even when the yield curves do invert, a recession is not immediate. In fact, there could still be opportunities for investors to turn a profit in the markets.

“The average time between when a yield curve inverts and a recession begins is about 14 months,” he says. “From December 2005, the start of the yield curve inverting, until December 2007, which marked the official start of the recession, the Standard & Poor’s 500 returned 22%. You don’t want to get burned taking all your money out just because the yield curve inverts. It’s important to know what it means and what the predictive power of it can be.”

Pointing to data derived from TD Ameritrade’s Investor Movement Index, which allows users to track what the firm’s 11 million customers worldwide are actually buying and selling, Kahling says the majority of customers are trading stocks that they are more familiar with, such as blue chips, and not really getting into “riskier” assets.

“In the current economic environment, what we’re seeing our customers doing now is [trying] to find the more defensive plays. They are worried about the recession,” he says. “[Investors are] moving away from tech stocks to stuff that’s more defensive, something like healthcare.”

Overall, Kahling says he is still bullish on US equities in 2019. But he warns that it is going to be a bit more difficult than in 2017, and investors have to spend a little more time to find the stocks with value.

“I think it’s really important at this point now that everyone is aware of the risks that are out there,” Kahling says. “There is not any kind of imminent risk... I think what we’re seeing now is just volatile times with the trade war. We do expect some kind of resolution; hopefully, in the first quarter of 2019. That’s going to give the economy and the markets some kind of clarity and a little bit of a boost.”

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