The State of the Economy

Posted by on Aug 22, 2019

August is one of the weakest months, historically, in the market year. Most traders and money managers are away and, as a result, trading volumes are usually pretty low. When volumes are low, any type movement tends to be exaggerated…much as we have seen these past couple weeks.

A couple of the topics that have caused most of the market reaction are related to either the inverted yield curve and/or a recession being right around the corner. Let’s look at these and see just what’s up.

YIELD CURVE

Tell the truth. Before a couple weeks ago, had you ever even heard of the yield curve – much less, an inverted one? Thought it maybe it might mean some road construction thing???

The yield curve is simply a line that plots the interest rates, at a point in time, of bonds having equal credit quality but differing maturity dates. The most frequently referred to yield curve compares the three-month, two-year, five-year, 10-year and 30-year US Treasury securities.

A normal curve is one where you see the plotted curve moving out to the right on the graph and up. The reason is that, when you loan someone money through a bond investment, the longer you loan it, the more interest you should expect as your (time) risk is higher. That’s normal.

However, when the short-term rates go above the longer-term numbers, you now have the inverted yield curve. And, in the past, an inverted curve has been an early tripwire for a recession.

But wait…there’s more.

Bonds trade in a global market.

This time, instead of concern about our economy forcing a focus on the 10-year US Treasury (UST) note, the most obvious and benign explanation is that investors see $15.8 trillion in negative-yielding debt worldwide, plus mounting geopolitical risks and an undercurrent of weakening economic data, and conclude that the longest-dated Treasuries are a way to lock in maximum yield and safety. That certainly seems plausible.

By the way, the only way you can make money on a negative-yielding issue is if rates were to go even lower from here – something the Euros seem to think will be happening there.

We have long argued that investors should not take the action in the bond market as a recession signal. Rather, we think it is all about capital flows from the rest of the world seeking a positive interest rate return in an environment where there is $16 trillion of paper with negative interest rates. AKA, money goes where it’s treated best…

The US only issues a finite number of bonds across all maturities. As this is written, the 10-year German Bund is at a negative 0.34%. The 10-year UK GILT is at 0.52% and the Japanese 10-year paper is at negative 0.24%. The US 10-year is at 1.60%.

You don’t need a Ph.D. in math to know that our yield/return is way better than most other sovereign bonds out there…and neither does anyone else.

I contend that it’s this huge global demand for our 10-year paper that has caused the price of that bond to drop, occasionally and momentarily, and making it invert.

We were around when the 30-year T’bond yielded roughly 15% and NOBODY wanted to buy it. Last Thursday, the 30-year yield fell to below 2% and everybody wanted to buy it. Welcome to the theory of market relativity…

And another thing…the market and media reaction to the inversion (minus 800 Dow points) was as if this would result in an immediate trip to the down elevator with no interim stops. Crikey! Understand that traders do, in fact, trade on headlines and not fundamentals so they will react quickly to whatever they see happening in the market – right then.

Here’s a fact to help fend off this inaccurate thinking.

The yield curve inverted in 1965 and the next recession didn’t start until 1969. The yield curve didn’t invert until after the 1968-1970 and 1973-1974 bear markets had already begun and failed to invert before the 1987 one-day sale. When the yield curve does lead, the market often appreciates meaningfully by the time the market peaks.

Dr. Ed Yardeni, president and chief investment strategist at Yardeni Research, offered this gem: “An inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn’t as accurate a predictor of economic downturns as widely believed.”

RECESSION

The National Association for Business Economics has found that 34% of economists in a new survey say they expect a US recession by the end of 2021. (Not exactly going out on a limb by adding another two years added to a 10-year run…)

Fact. Recessions are not forecastable.

The interest rate situation is certainly weird, but it doesn’t tell us much about whether there’ll be a recession. Thanks to the media and some politicians, the threat of a recession is on the minds of investors. This link between an inverted yield curve and a recession has so dominated recent financial news that for some investors, it’s no longer a matter of whether we get a recession, but how long until it starts. 

So how does CNN et al  “warn of a looming recession” when there’s not a single economist forecasting a negative GDP for the third quarter?  By definition, a recession begins after we have had two sequential quarters of negative GDP growth.

First quarter GDP growth was 3.1%. Second quarter GDP growth was 2.1%. And now, somehow the third quarter is suddenly going to be negative growth?  Don’t think so.

And, if the Treasury market is signaling an imminent recession, somebody forgot to tell US consumers. Retail sales were just reported as 3.4% above their year-earlier level. There wasn’t any one thing behind the strength in spending—it was broad-based.

So, don’t start the anxious heavy-breathing just yet.

Further, pretty much everyone agrees that housing isn’t grossly overvalued like it was in the years before 2007-2008. But some think we now have overvaluation in the stock market, so a downdraft in stocks will play at least part of the role previously played by real estate, perhaps like back in the 2001 recession. 

The problem with this overvalued market theory is the capitalized profits model FirstTrust uses to assess “fair value” on the stock market says stocks were substantially over-valued at the peak of the first internet boom before the 2001 recession but are still under-valued today. 

The price-to-earnings ratio on the S&P 500 peaked at 29.3 in June 1999 (end-of-month, based on trailing 12-month operating earnings). At the end of July 2019, the same ratio was 19.3, more than one-third lower. Meanwhile, the 10-year Treasury yield finished June 1999 at 5.81%. Investors today would kill to get that kind of safe yield, versus the 1.55% we had at Friday’s close. In other words, the stock market is nowhere near the situation it was in about twenty years ago. 

I firmly believe that there is a case to be made that valuations should be higher these days because of the economic environment. Interest rates have been low for going on a decade now and inflation is basically non-existent. When interest rates and inflation are low, valuations tend to be higher.


Let’s also think about the recessions of 1990-91 and 1981-82, both also preceded by inverted yield curves, but also preceded by a heck of a lot else.

The bottom line is that yes, the yield curve inverted prior to each of the recessions we discussed, but there were a lot of other things going on, not just the inversions. This time around, we don’t see a catalyst: no housing bubble, low capital ratios among US banks, mark-to-market rules that can turn a downturn into an inferno, a bursting stock market bubble, or a stubborn rise in inflation that the Fed has had to choke off with tight money. Without any of those ingredients, we still believe those predicting a recession in the near term are, to be extremely polite, way too pessimistic.

You have to be careful trying to infer something from everything, because in today’s world, it is virtually impossible to separate the signal from the noise.

According to Franklin Templeton, these are the types of issues that have brought the end to bull markets in the past:

  • rapidly rising inflation or interest rates,
  • the buildup of speculative excesses or bubbles, or
  • a geopolitical shock that impacts demand.

The current US bull market has been running for more than a decade, which is long by historical standards. However, it has also been very shallow and slow compared to past periods of economic expansion. This slower rate of growth is a direct result of the severity of the global financial crisis a decade ago, and the low-inflation, low-interest-rate environment that followed.

“We’re not convinced that this yield curve inversion is a sign of imminent recession,” said LPL Research Chief Investment Strategist John Lynch. “The US labor market is at full employment, healthy wage growth is fueling strong consumer activity and corporate profits are at record levels.”

Bottom line: The inverted yield curve is noteworthy. But…the yield curve isn’t an on/off switch for the US economy as a whole. The US economy could very well fall into a recession but that’s still off down the road. If a recession does occur it will be for a host of reasons. The yield curve would be a factor, but not THE overriding factor.