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The U.S. Is Getting Closer to a Recession, Data Show [marketwatch.com]

Some new research suggests we’re in the late innings of this expansion. The Fidelity Asset Allocation Research Team, which advises Fidelity’s fund managers, studies the business cycle, because they believe it helps determine the direction of stocks. In a recent report, it said the U.S. entered the late stage of the business cycle late last year.

Read: Why the S&P 500 Needs the VIX to Keep Falling if it Wants to Keep Rising [barrons.com]

We have plenty of company, as the chart below shows. Developed economies like Germany, France and Italy are much deeper into the late stage of the business cycle, as are Canada, South Korea and Australia. Emerging markets like Brazil, Mexico and India also just entered the late phase. The U.K., reeling from pre-Brexit chaos, is on the cusp of recession. China, the researchers say, is already there, although they define it as a “growth recession” because the Chinese economy has marked slowdowns, not actually negative growth.

This matters to investors because, although bear markets are only fair predictors of recessions (seven of 13 postwar bear markets were followed by economic downturns), bear markets that precede recessions tend to be longer and deeper, averaging declines of 37%. So if the economy is indeed in the final phase of its long recovery, that’s a warning sign to investors to get more defensive.

“We’ve just been through the best parts of the cycle for risky assets,” Dirk Hofschire, Fidelity’s senior vice president of asset allocation research, told me in a phone interview. (His team’s views are not necessarily the official position of the Boston-based firm, which managed $2.5 trillion as of last March.) “Late cycle is sort of the transition phase. By the end of the cycle, when we move into recession, that’s when you would want to be a little more risk-off.”

In the early phase of the business cycle, economic activity rebounds sharply, and credit and profits grow again amid loose monetary policy. It lasts on average one year. The mid-cycle phase, which goes for about three years, is characterized by peak economic and profit growth and more neutral monetary policy. The late phase, whose average duration is a year and a half, shows slowing GDP and profit growth amid central bank tightening. After that comes recession, and then the whole party starts again.

Hofschire acknowledges the current business cycle has hardly been “average,” either in duration or depth. “We didn’t get as fast of a snapback. When you come out of a financial crisis, it is harder to [get] the economy back to prior growth levels right away,” he said. “You go through a deleveraging process … that is very, very painful and takes some time.”

That long, slow recovery has been accompanied by subdued inflation and extraordinary actions from the Federal Reserve and other central banks — massive bond purchases and, in Europe and Japan, negative interest rates. Also, in late 2017, President Trump signed the Tax Cuts and Jobs Act, which provided what looks like a temporary boost to earnings and GDP after eight years of recovery.

Those factors may have stretched out the business cycle, but Hofschire says they didn’t repeal it.

“When we go back and look at the actual patterns, they are more consistent with prior business cycles than might appear at first blush,” he said. The four increases in the federal funds rate last year and the shrinking of the Fed’s balance sheet, now both on hold, will likely be accompanied by a slowdown in earnings and economic growth this year.

Read: Stock Market Bulls Should Be Worried About This Data Point [barrons.com]

That’s a classic sign of the business cycle’s last phase before recession sets in, and it’s reflected in recent stock performance. From the Dec. 24, 2018, closing low to the Feb. 5 closing high, the Industrial Select Sector SPDR ETF was the best performing of all the Sector SPDR ETFs, by my calculation, with a 21.7% gain. Energy Select Sector SPDR was second, followed by Communications Services.

Those classic, late-cycle stalwarts easily topped the S&P 500’s 15.1% gain, as well as beating early-cycle winners like consumer-discretionary and financial stocks and typical mid-cycle technology.

Hofschire thinks this phase is a good time to lighten up on economically cyclical assets and move toward high-quality bonds and defensive sectors such as consumer staples, health care and utilities, which outperform during recessions.

“You rein in your active risk, and you don’t take a lot of cyclical risk, for the simple reason that you don’t really know what’s coming next,” he says.

Almost 10 years into the recovery from the Great Recession, we don’t know when the end will come, but it’s certainly in sight.

Howard R. Gold is a MarketWatch columnist. Follow him on Twitter @howardrgold [twitter.com].

This article originally appeared on MarketWatch. [marketwatch.com]

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