Investors are expressing rising concern about potential recession next year, based on the inverted yield curve in the bond market.
We did a comprehensive analysis in March (click here to access that report), providing our view on how to interpret the yield curve, what history tells us about inversion, and how stocks have behaved over the past seven periods of inversion.
Our conclusions from that report remain the same, but with recent market volatility we thought we would provide additional context.
- Sustained inversion of the yield curve is cause for concern because it has historically been a good predictor of recession. Since the spring, the yield curve has become more inverted, which does raise incremental—but not definitive--risk. See update below.
- The trade war between the US and China is affecting economic growth in most major economies at this point—most notably in Germany and China. The US continues to show relative strength, but it is arguably not immune. The direction of the trade war will influence yield curve dynamics (inversion and recovery), in our view, but the turns will be hard to anticipate. See our latest full analysis on the trade war here.
- As we illustrated in our March report on inversion, selling stocks while trying to interpret the yield curve is—counter-intuitively—more likely to hurt returns than help them. We therefore recommend that clients with long-term horizons stay with their policy allocations.
- That said, we do think investors should brace for increased volatility as markets sort out the unfolding economic outlook. Investors with high withdrawal rates on their portfolios should carefully manage spending.
Updated Yield Curve Analysis
The exhibit below illustrates the trend in yield curve inversion. It shows the spread, or difference, between the 10-year Treasury bond and various shorter-term Treasury bonds/bills, for different periods. When the difference is positive, the curve is upward sloping and healthy; when the spread is negative, the curve is inverted and a concern. Since March, the spreads have become more negative and broader-based.
We point out some key variables:
- The yield curve is unfolding in real-time and is dynamic. It is tangibly affected by Fed policy, trade war developments, and even Presidential tweets. Positive developments in these areas could quickly reverse recent trends, in our view. It’s obviously hard to predict any direction.
- Many other key leading economic indicators in the US are not yet flashing red. The Conference Board, for example, tracks ten indicators (one of which is inverted spreads) often expected to predict economic trends, which point to steadier forces.
All-in, the bond market is being influenced by several forces but has not yet sent a declarative signal about recession. Nevertheless, we believe the incremental risk is higher.
Recent Economic Trends outside the US
The mounting US-China trade war is beginning to have a measureable impact on economic growth:
- Germany reported a slight contraction in its economy for the quarter ending June 30. China is a large trading partner for Germany in cars and capital goods. Economists are still forecasting flat-to-barely positive economic growth for Germany in 2020.
- China is showing signs of pain from a protracted trade war, reporting weaker than expected results in factory production and consumer spending during July. Economists expect additional stimulus from the Chinese government to maintain target economic growth of 6% to 6.5% annually.
On top of this, the threat of the UK leaving the European Union by October 31 without a negotiated set of trade deals is rising, which could add to pain felt by Germany and other Euro nations. Britain and Sweden reportedly posted slightly negative economic growth for the quarter ending June 30.
This negative economic news does not mean that the US economy will necessarily hit recession—and current trends remain largely healthy—but it does increase the risk.
As stated in our March report on yield curve inversion--
A sustained inverted yield curve is a cause for concern. While it sends a clear signal only in hindsight, we believe it does point to an increased risk of recession in the next two years.
Taking “risk” off the table by reducing equities is not an appropriate response, however, for most investor groups. There is high risk of misinterpreting signals that are only clear in hindsight, and while exiting the market may feel comfortable near-term, the decision to re-enter the market is often difficult. For our clients, we strive to accommodate periods of volatility by constructing portfolios with the appropriate level of risk to meet their long term objectives.
Most importantly, the downside risk of being “out of the market”— i.e., deviating from your long-term investment goals—is high, considering that being out of the market for only the 22 days with the highest return for the S&P 500 would have resulted in a 0% cumulative return since the beginning of 1999. Stocks are forward-looking and are likely to rebound when you least expect it.
 Their indicators for the US include: average weekly hours (manufacturing); average weekly initial claims for unemployment insurance; manufacturers’ new orders (various industries), ISM Index of New Orders; building permits (new private housing units); stock prices (S&P 500); Leading Credit Index; interest rate spreads (10-year Treasury bonds less federal funds); and average consumer expectations for business conditions.