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When Will the Next Recession Come? 2 Factors to Watch

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The future of U.S. financial markets depends on two major variables: the eventual outcome of the U.S.-China trade dispute and Federal Reserve interest rate policy, specifically how soon and how much the central bank cuts.

Those are two of the biggest takeaways from Schwab’s midyear market outlook webcast with its chief investment strategists and officers for stocks and bonds.

“Trade is the most important needle mover” concerning the timing of the next U.S. recession, which is a “100%“ certainty, said Liz Ann Sonders, chief investment strategist at Charles Schwab & Co.

Markets could learn as early as this weekend how far and what direction that needle will move when President Donald Trump and China’s President Xi Jinping meet on the second day of the Group of 20 summit in Osaka, Japan, this Saturday.

Failure of the talks could well be followed by the U.S. imposing 25% tariffs on $300 billion worth of imports from China on top of the 25% tariffs it has already imposed on $250 billion worth of Chinese goods. China has retaliated with tariffs of its own on about $110 billion worth of U.S. imports.

If U.S.-China trade conflict continues to deteriorate, then “a major haircut” is expected among Wall Street analysts’ expectations, said Sonders. “The risk is on the downside.”

Failure of U.S.-China trade talks also increases the likelihood that the Federal Reserve will cut interest rates sooner than later. Fed Chairman Jerome Powell said as much after last week’s Fed policymaking meeting and on Tuesday in a speech to Council of Foreign Relations in New York.

“Crosscurrents have re-emerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy,” said Powell. “Many FOMC participants judge that the case for somewhat more accommodative policy has strengthened.”

Brett Wander, Schwab’s chief investment officer for fixed income, said the financial markets are now pricing in a Fed rate cut at its next meeting in late July followed by as many as two additional cuts through the rest of the year.

“It would be an absolute disaster if the Fed doesn’t cut rates and undermines its credibility. That would cause investors to panic and make for some very interesting tweets,” said Wander, referring to possibly more Trump tweets about Powell and the Fed.

Trump has been criticizing both in tweets and speeches in recent weeks and has looked into the possibility of demoting the Fed chairman to his previous position as a Fed governor, according to Bloomberg, but the White House denied the story.

If economic indicators do deteriorate and the Fed doesn’t cut rates as expected and there’s more negative talk about Powell, then markets will react negatively, said Sonders.

Another negative for financial markets is the inverted yield curve, which is a “solid indicator of a recession 12-18 months later,” said Kathy Jones, chief fixed income strategist at Schwab. But she said the inversion in this cycle is unique because it hasn’t yet led to a pullback in bank lending. “A recession is coming but not all the indicators are falling in place to say it’s imminent,” said Jones.

She favors a barbell strategy for bonds, investing in short- and intermediate-term bonds, up to seven years maturity, rather than just short-term bonds, which currently have higher yields. Once the Fed cuts rates, investors will be reinvesting short-term bond proceeds at lower yields, so having longer-term bonds will allow them to lock in higher yields, explained Jones.

Wander agreed. “It may be that true shorter-term bonds offer higher yield with less duration risk, but that strategy will lead you to miss out the appreciation associated with long-term maturities as rates decline.

“In the past 20 years when there was an inverted yield curve, you would have done better investing in longer rather than short-term securities three out of 10 times.”

Wander also cautioned against increasing exposure to high-yield bonds.

“We are in a global economic slowdown,” said Omar Aguilar, chief investment officer of equities and multi-asset strategies. “Nothing is working except growth, and large-caps are doing well.”

He also recommends that U.S. investors increase their allocation to foreign stocks, which is about 15% on average. “The biggest driver to increase international allocation has to be where the dollar been,” but a Fed rate cut would devalue the dollar, creating more opportunities for international investing, said Aguilar.

— Check out Why LPL Is Bullish on Stocks on ThinkAdvisor.


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