Black Cypress portfolios handily beat their benchmarks in August.

Equity market performance was a reflection of political turmoil and mixed economic data. The debt ceiling debate created needless uncertainty. While the ceiling was raised in early August without any actual budgetary impact, it hurt investor and consumer sentiment. Adding insult to injury, Standard & Poor’s downgraded the United States’ credit rating one notch days later. Regional manufacturing reports pointed to contracting output and initial unemployment claims began to rise. Real GDP growth for the second quarter was revised down to only 1.0%, bringing the economy’s year-over-year growth rate down to 1.5%, below the feared “stall speed” level of 2.0%. Much research was released that every time the economy’s year-over-year growth rate has fallen below 2.0%, a recession soon followed.

Despite continued weakness in data, policy actions taken in early August by the Fed and the potential for more at any sign of weakness so far continue to limit declines and add support to equity markets. The Fed is expected to announce additional easing measures–either in wording or action–on September 21 and the President has requested another $500 billion in stimulus from Congress. To help stabilize the continuing Euro sovereign debt crisis, the European Central Bank, the Bank of England, the Bank of Japan, the Swiss National Bank and the Fed announced a coordinated effort to supply liquidity to the Euro zone. Measures like these are hoped to ease stress within the system and allow further time for the economy to grow.

This intervention, while welcomed, also changes the game of risk management. Thus far, the proprietary Black Cypress macro model has not signaled an imminent recession. But if and when it does, the logical move is to limit risk. This could be done in a variety of ways, including selling all equities, selling more economic-sensitive equities, purchasing hedges, shorting stocks, or some combination of these. But with the sensible move comes a new risk: that the government, in the form of Congress or its central bank, will institute further immense fiscal or monetary stimulus, thus punishing our prudence with relative underperformance. Of course, both forms of stimulus have thus far had limited success at creating a sustainable recovery. At some point the market’s affinity for our government’s effort to cure what ails us–simply by throwing more money at the problem–could change for the worse.

With all that said, the probability of a recession is the highest it has been since December 2007. In fact, only one data point within our model holds back our expectation of a forthcoming recession–and the changes to portfolio construction that would come with it.