No Country for Recessions

The frequency of U.S. recessions has significantly decreased over time, falling from 45% of months before 1940 to just 8% since 1991, attributed to the economy's shift towards services, effective countercyclical monetary and fiscal policies, and globalization. This trend is largely expected to persist, leading to a correlation with higher equity price/earnings multiples and increased stock valuations, as investors face reduced earnings volatility and greater confidence in bidding up asset prices.

Analysis

A structural analysis of U.S. business cycles reveals a pronounced decline in the frequency of recessions, with data showing the proportion of months in recession falling from 45% pre-1940 to just 8% since 1991. This secular trend is attributed to three primary drivers: the economy's transition from manufacturing to services, which mitigates inventory-driven slumps; the post-WWII adoption of countercyclical monetary and fiscal policies designed to smooth economic cycles; and the disinflationary impact of globalization that fueled the 'great moderation'. While this regime of infrequent recessions is expected to persist, anchored by a dominant services sector and proactive policymaking, a partial reversal of globalization is noted as a key risk that could increase supply-side shocks and inflationary pressures. This macroeconomic stability has a direct and significant implication for equity markets, as evidenced by the strong negative correlation between recession frequency and the Shiller P/E ratio since 1950. The underlying thesis is that fewer recessions lead to more stable corporate earnings, thereby reducing investor risk perception and justifying structurally higher valuation multiples.

Key Decisions for Investors

• The structural decline in recession frequency provides a fundamental justification for higher long-term equity P/E ratios, warranting a continued strategic allocation to equities despite what may seem like elevated multiples.
• Investors should closely monitor trade policy and inflation data, as a reversal in globalization is the primary identified threat to the era of stable growth and could introduce significant supply-side volatility.
• Given that countercyclical policy is expected to continue and possibly expand, investors should assess the dual impact of growth support and heightened inflation risk, considering portfolio hedges against rising price levels where appropriate.