- Recent weakness in the global economy has not been completely broad-based.
Geographically, Europe (and Germany in particular) is showing the most vulnerability as measured by recent readings on business sentiment, manufacturing, trade, and output. In contrast, while the US isn’t going gangbusters, growth is holding up a bit better. Moreover, weakness by sector is variable. For example, in the US, the manufacturing, capital expenditures, and external sectors (e.g., net exports) are struggling in the wake of the US-China trade standoff, but consumption (nearly 70% of US GDP) is solid as employment remains robust and wage gains continue to outpace inflation.
- While we think the economy is slowing, we don’t see a US or global recession in the next 6–12 months as a foregone conclusion.
Our belief for the last year has been that the developed market economies would naturally slow to their longer run supply-side potential. In the US, that’s around 2% real GDP. In Europe, it would be closer to 1% GDP. Not great, but not negative either – not a recession. For now, the slowing in the US Leading Economic Indicators looks similar to the mid-cycle slowdowns of 2011–12 and 2014–15. Because consumption continues to do the heavy lifting, we will be watching leading employment trends closely (weekly jobless claims being key) to see if there are cracks in the consumer foundation.
- Contrary to some reports, the continued inversion of the yield curve is worrisome, as highlighted by the 2s/10s Treasury yield curve briefly going negative on August 14.
It is worrisome because the yield curve is arguably both predictive and contributory. Many have argued that the predictive accuracy of the yield curve has been impaired by extraordinary monetary policy – essentially that bond yields and prices are being artificially set by central banks, not market forces. This is true to some extent. We agree that the predictive power of the inversion may be impaired, but we doubt it has lost all its value. Sadly, investors won’t know until after the fact whether the curve was predictive of recession or not.
However, debating the predictive power of an inverted yield curve misses a key point: An inverted curve, if the condition persists long enough, can eventually create recessionary forces by dampening credit growth. Pushed far enough, banks will have less incentive to lend, as their cost of funds at the short end outpaces their income from extending credit at the long end. For both of these reasons, we take the deteriorating slope of the curve as a cautious sign.
- The effects of an inverted yield curve have a highly variable lag.
Historically, the time elapsed from curve inversion to either a recession and/or a bear market in stocks has ranged from never (a false signal), to a few months, to a few years – averaging perhaps 12–18 months. This has emboldened some investors to stay in risk assets (or increase them as high quality bond yields plummet) rather than get out prematurely. In this case, however, investors should be highly skeptical of “the average.” In today’s markets, asset prices reflect news flows instantaneously and money courses through the veins of the capital markets faster than ever before. So investors who choose to “hang on till the end” have to be right – now (no recession) – and know when to get out later. We’re dubious that such market-timing prowess exists.
- We continue to believe that portfolios should be cautiously positioned because the risk/reward tradeoff continues to deteriorate.
For now, our base case is not for recession, but we see the upside as being limited. Earnings growth over the next few years should be positive, but it will be sub-par. Valuations are not extreme, but they are elevated, implying limited multiple expansion from here. We don’t think the Fed’s accommodative pivot will be a game changer nor do we expect much real progress in US/China relations. Caution, however, does not mean dumping risk assets (again, we’re skeptical of market timing), but can mean finding lower-volatility, lower-risk ways of staying in the market. This might include emphasizing value, augmenting hedges, or using strategies that will lower correlation to the equity markets.
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