A recession signal with a multi-decade track record is cropping up again, and it has Wall Street on standby for the next crisis
- The Federal Reserve has firmly signaled that it will not raise interest rates until risks to the economy subside.
- Some Wall Street strategists are convinced that this stance marks the end of the Fed's hiking cycle and is a prelude to the next recession.
- Their views - and what this means for stocks - are outlined below.
If you had to pick just one catalyst that explains the stock market's rally this year, the Federal Reserve would be a solid choice.
The central bank took steps to reassure markets that it will not raise borrowing costs as aggressively as many feared, considering the evidence of softness in parts of the economy. Minutes for its January meeting released this week showed it even shouldered some responsibility for the sell-off late last year.A more patient Fed can help fill potholes in the economy and keep financial conditions loose enough to keep fueling stock-market gains.
However, some strategists are reading the Fed's patience differently: as a signpost effectively marking the end of this rate-hiking cycle. They believe the burgeoning evidence of a US economic slowdown, coupled with the risks introduced by the trade war, is digging a hole that investors won't be able to climb out of.
"The end of the Fed tightening cycle is more often than not, a prelude to recession," said Albert Edwards, a strategist at Societe Generale who is well-known for his bearish views on the global economy.
If the Fed is indeed done, history suggests that the next recession might still be years away. According to data from LPL Financial, the average span from the final hike to recession over the past 40 years has been nearly three years.
However, the concern for strategists like Edwards is that the timeline will be shorter this time around.They see a familiar pattern playing out: The Fed raises rates rapidly, pauses when there are signs of strain, and then quickly cuts rates to contain an unfolding economic meltdown. This happened most recently in the 2000 and 2008 recessions, and it's why the Fed has been blamed in some way for every crisis in the postwar era.
Edwards has long warned that the next recession could be so dire that the Fed will have to cut rates into negative territory - something it has never done before.
He says investors should not dismiss the economy's warning signs and how the Fed is responding.
"Where investors could easily be caught out is in dismissing recent weak US economic data as due to one-off factors such as the very cold weather or the government shutdown," Edwards said in a note to clients. "Investors need to be doubly cautious at this late stage of the cycle."
One person who's already cautious is David Rosenberg, the chief economist at Gluskin Sheff. For example, after retail sales plunged by the most since 2009 in December, Rosenberg did not dismiss it as a one-off.
Of Rosenberg, Edwards wrote: "He calculates that large declines in retail sales of this magnitude are associated with recessions 80% of the time. Free money may have numbed our senses, but at this very late stage of the economic cycle, think very hard before stepping off the sidewalk."
In a note exclusively published by Business Insider, Rosenberg further said he believed the next move in interest rates will be down, not up.The legendary economist Gary Shilling is also on recession watch, and has warned that Fed tightening could trigger the next one. He cites the fact that inflation has languished below the central bank's 2% target despite the plunge in the unemployment rate to 3.9%; both metrics historically have a negative relationship.
"The likelihood of a recession starting this year, which I rate at two-thirds probability, is also deflationary," Shilling told Business Insider by email. "That would end and reverse the Fed credit tightening campaign that started in December 2015."
If Fed tightening is truly over, stock-market bulls may still be able to buy time. The S&P 500 gained by an average of 9% and 12% in the six- and 12-month periods after the final rate hike, according to LPL Financial.
But the cautionary tale here is that investors may struggle to come to terms with the next about-face from the Fed.