If this economic expansion was a party, it would now be getting late in the night. With US unemployment near the lowest level since 1970, the party is still in full swing. However, the lower unemployment falls, the higher the risk of a recession is. That’s because the Fed’s job is such a difficult balancing act. 
When unemployment is high, the Fed keeps interest rates low to stimulate the economy. Historically though, once unemployment is low workers demand better pay rises and hence put upward pressure on prices. So once the unemployment rate is low the Fed starts to worry about things getting too heated and raises interest rates, gradually removing the punch bowl from the party.
The Fed have to raise interest rates enough to stop unemployment from falling so low that inflation starts to rise faster than target but without raising rates so much that it causes a recession. The theory is that there is a level of interest rates at which the unemployment rate will stop falling and instead just go sideways, with inflation neither too hot nor too cold.
However, economies exhibit momentum. For example, unemployment tends not to go sideways for very long, it tends to keep falling and then eventually rise quickly. That’s because falling unemployment tends to cause higher spending and so further falls in the unemployment rate. But once workers have sufficient bargaining power, they tend to keep demanding pay rises until they no longer have bargaining power.
The problem is that it’s not clear from history that, once unemployment is at very low levels, the Fed can raise interest rates enough to stop wage pressure from building, other than by raising them to a level which causes an increase in unemployment. And then the economic momentum starts to tip against the Fed very quickly. As once unemployment starts to rise, consumer confidence and spending falls and so unemployment rises further and before you know it there’s a recession.
The Fed’s balancing act is made even harder because it can take some time before low unemployment starts to translate into wage rises, by which point unemployment will probably have fallen further below the point at which workers have bargaining power. Also, once interest rates start to rise it takes time for that to dampen the economy, by which time interest rates will probably have risen further. So, even if it was possible to perfectly balance the economy for more than a brief period of time, time lags make achieving the right balance even more difficult.
As if that wasn’t hard enough, this time around, there’s an extra challenge in that just as the Fed is trying to reduce the amount of monetary stimulus on offer, the US administration has stimulated the economy by adding fiscal fuel to the fire. This could cause the Fed to raise rates faster than it otherwise would, potentially leaving rates too high for the economy once the fiscal stimulus fades.
So, as the Fed engage in their difficult balancing act, don’t be surprised if eventually the economic momentum starts to tip from a positive to a negative feedback loop and the US ends up in recession at some point in the next few years. Therefore, at the same time that the Fed are attempting to perfectly balance the economy, the argument is growing in favour of a more balanced portfolio.
That balance can be achieved by moving closer to neutral benchmark weightings in risk assets such as equities, credit and commodities and balancing them with targeted absolute return funds with a focus on downside protection, both within fixed income and alternative strategies. Investors should also consider reducing any overweights to mid- and small-cap equities and growth stocks. Both have outperformed significantly during this bull market but could be particularly vulnerable during the next recession, when company earnings expectations aren’t met.
The party probably isn’t over just yet. However, as it gets towards the end of the night, there’s a balance to be struck between still enjoying yourself, while dancing closer to the door. You don’t want to be last in the queue for the coats when the music suddenly stops and everyone rushes for the exit.
Mike Bell is a global market strategist at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.