Risks of an overheating US economy

Schroders
Simon Doyle
Simon Doyle
Schroders Head of Fixed Income and Multi-Asset
The US economy and corporate profits have been strong. It’s times like these that investors should start to worry about monetary policy tightening killing the bull market.

On many occasions we have commented on how markets look stretched, based on valuations, pointing to a low return outlook over the next three years. The other side of this coin is that markets are also more vulnerable to shocks — the more stretched valuations are, the greater the likely downside shift if markets are confronted with negative news. It is therefore prudent to scan the horizon for likely shocks that may destabilise markets. The most damaging of shocks would be a US recession.  A typical shock will see greed turn to fear, and often leads to a 20%-plus fall in share markets, like the European shock in 2011.

Unsurprisingly we spend a great deal of time determining the risk of recession. Our modelling has found there are generally three phases leading into a recession. First, the economy begins to see signs of overheating — goods and labour markets are tight and inflation pressures start to build. This generally occurs one to two years before a recession. Then, the central bank responds by raising interest rates and draining liquidity out of the system. Policy becomes tight, and with a lag of six to 12 months, this leads to a recession. The last leg to fall is when we start to see it in activity, with investment and employment falling and consumers beginning to rein in on their spending.

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Watching this space for further signs of recession risk

It's going to be interesting to see how this unfolds over the next year or two.

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