Markets are struggling. Global growth is slowing. And as attention increasingly turns to the possibility of a recession, it’s time to stop pondering when an economic slump will set in, and focus instead on what it may entail.
In short, we believe a recession appears in store for the U.S. by the end of 2020—and possibly sooner. Why? The recent slide in U.S. equities—the S&P 500® Index dropped nearly 14% last quarter1—suggests that the bull market likely peaked early last fall. In the post-World War II era, markets have reached their high point, on average, roughly six months before a recession—and the longest distance from a market peak to a recession has been 12 months (although the 1987 bear market was outside of a recession).
Source: Thomson Reuters Datastream, National Bureau of Economic Research, Russell Investments
While it’s impossible to nail down the precise timing of the next economic slump, absent a crystal ball, there’s little doubt in our minds that the economy will experience at least two consecutive quarters of declining GDP (gross domestic product) growth—the definition of a recession—by the end of 2020. Although the calendar alone does not drive recessionary risk, this economic cycle has lasted a very long time: If the nation’s economy is still churning in August, the current period of U.S. expansion that began in June 2009 will officially become the longest on record—surpassing the 120-month stretch of growth from March 1991 to March 2001.2 Put another way, never before in the history of the U.S. will a recession have been avoided for such a length of time. During this time, economic imbalances have built up—as they always do—and these areas of unsustainable economic activity will, in our mind, end in recession. But, will the next U.S. recession be as severe as the last?
Our answer: Highly unlikely.
The next recession: No 2008 sequel
Mere mention of the word recession sends shivers down the collective spine of many in the industry, as the first thought that comes to mind is 2008: the global financial crisis (GFC) and the staggering Great Recession that accompanied it. But, remember that 2008 was the second-worst pullback in the U.S. economy on record, topped only by the Great Depression. In other words, from a recession standpoint, it was much more of an anomaly than a norm.
What’s more, the Great Recession was consumer-driven, sparked by record levels of debt. Consumer-led recessions, in particular, tend to be extraordinarily painful. Why? Because as personal debt levels rise, people are forced to use income to pay down debt. This, in turn, leads to a sharp reduction in consumer spending—a real problem in the U.S., where consumer spending accounts for roughly 70% of the economy.3
10 years removed from the Great Recession, the picture today looks much brighter. For starters, the American consumer is in far better shape than a decade ago—ironically because of the Great Recession. In its aftermath, debt-burdened consumers were forced to massively alter their spending habits, and they did. In general, this has led to a much more financially-responsible consumer—one who generally has focused on paying off debt, rather than borrowing additional money. Broadly speaking, today’s consumer is not over-leveraged—in stark contrast to 2008.
The same holds true for banks. It’s no secret that over-leveraged financial institutions leading up to the GFC played a large part in the nightmare of 2008. Fortunately, banks today are on much more solid footing, with capital ratios drastically improved in the ten years since.4
All things considered, the parallels between today’s economic backdrop and 2008 look to be few and far between. In order to gain a more accurate portrayal of how we think the next recession will unfold, let’s travel back in time a bit further. Back to the halcyon days of the late 1990s—the peak of the dot-com era.
The booming 90s: Soaring economy, skyrocketing stock market. Sound familiar?
As the clock ticked toward Jan. 1, 2000—remember Y2K?—America was flying high. The U.S. economy, powered by the rise of a booming tech sector and the explosion in popularity of the internet—was soaring to new heights. Annual GDP growth rates from 1997-1999 had exceeded 4%.5 The unemployment rate had tumbled from 7% at the start of the decade to approximately 4% by 1999—the lowest for the nation since the late 1960s.6
Not surprisingly, the stock market had also gone fully stratospheric, with the Dow Jones Industrial Average tripling in value by the end of the decade—rising from 5,000 points in the early 90s to roughly 16,000 by the time Y2K arrived.7 The NASDAQ Composite® Index charted a similarly meteoric path, closing out 1999 at over 4,000 points—a four-fold increase in value in less than five years.8 The late 90s represented the icing on the cake of a historic bull market—one that began in October of 1990 and grew into the nation’s longest on record (at the time) by the summer of 1998.
This, of course, sent stock valuations through the roof, with Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio hitting an all-time high of 44.20 in December 1999—a mark which still stands to this day.9 In fact, for nearly two years centered around the turn of the century, the CAPE ratio for U.S. equities stood above 40. Contrast that with today’s stocks, which we believe are still expensive, and yet have never exceeded a value of 33 (reached in January 2018). This just goes to show that the equity market of the late 1990s was more than expensive. It was historically expensive.
And yet, just three months after the calendar flipped to the year 2000, a bear market was underway in the U.S.—with a recession arriving the following year.
Is the same fate in store for today’s bull market?
Someone (apparently it was not Mark Twain) once said that although history may not repeat itself, it often rhymes. To wit, it’s hard not to note the plethora of eerie parallels between the dot-com era and today. Recent GDP growth, punctuated by a 4.2% year-over-year increase in the second quarter of 2018, has been stellar. Unemployment rates have been nothing short of spectacular, plummeting to levels below those observed in the late 90s and matching 1969’s mark of just 3.7%.10 As for the country’s seemingly never-ending bull market? Last August, it topped the previous record of 3,452 days set in the 90s, and, despite a Christmas Eve scare, is now closing in on 3,600 days11. Just like back then, the tech sector has powered the steady gains. And, don’t forget about the length of the U.S. economic expansion, on track to take down yet another dot-com era record in a few months.
While this doesn’t necessarily mean today’s bull market is going to crumple dot-com style in the next few months, we strongly believe that the better days for U.S. equity investors are solidly in the rearview mirror for a long while. After all, U.S. stocks have outperformed all international developed stocks and emerging market equities for the past one-year, three-year, five-year and ten-year periods. Zooming out to a wider timeframe, history tells us this won’t last. During the nearly 40 year-period from 1970-2007, for example, U.S. markets and non-U.S. developed markets had an almost identical performance, with the U.S. charting a 11.06% gain, compared to 10.86% on the part of non-U.S. developed markets.12 In other words, looking at today’s bull market in the context of a greater time horizon strongly argues that what’s in store for the future of the U.S. stock market is a reversion to the mean. It probably goes without saying that this is very close to how the story played out in the early 2000s. Following a remarkable run where U.S. equities outperformed all other asset classes seven out of ten years in the period from 1991-2000, the script reversed, with non-U.S. markets beating U.S. markets seven out of ten times from 2001-2010.13
The next recession: Shades of 2001?
The parallels between today’s economic backdrop and that of the late 90s lead us to predict that the next U.S. recession will taste a lot like 2001. Fortunately, that’s about the best type of bad news there is. Why? In a nutshell, the U.S. recession of 2001 was very mild—and also lasted only eight months. That’s just two months longer than the minimum requirement needed for an economic downturn to be officially classified as a recession.
So, will the next recession play out in much the same fashion, fading in less than a year’s time? What impacts are possible on Main Street—is daily life for most at any risk of serious disruption? And, how about life on Wall Street—just how bad could the next market pullback be? How much pain may lie ahead for investors?
We’ll dig deep on all of these issues in a follow-up post. Stay tuned.
On the latest edition of Market Week in Review, Mark Eibel, director, client investment strategies, and Research Analyst Brian Yadao discussed 2018 market performance, the ongoing volatility in markets, the U.S. jobs report for December and projections for fourth-quarter earnings season.
2019 growth projections: The cause for the Q4 market selloff?
Looking back at 2018, Eibel noted it was an unusual year for U.S. equities, with three quarters of mostly positive returns, followed by a stomach-churning fourth quarter that saw the S&P 500® Index tumble 14%. The fourth quarter selloff occurred despite solid economic data and near-record low unemployment rates in the U.S., Eibel said, leading many to wonder why returns took such a hit.
“2018 is a great lesson in how the market is typically a forward-looking mechanism,” Eibel stated, “with investors often concerned more about what’s coming down the pike than what’s happening in the here-and-now.” The fourth quarter of 2018, he said, showed that markets were looking ahead to 2019 and the projections of a slowdown in economic growth and corporate earnings that accompanied it. Likewise, much of the market gains in 2017 were likely driven by the stellar growth forecasts for 2018, he said.
New year, same story: Volatility continues in markets
To say 2019 has kicked off on a volatile note in markets would probably be a bit of an understatement, Eibel said, noting the rollercoaster ride for stocks included a 660-point drop in the Dow Jones Industrial Average on Jan. 3, followed by an approximately 700-point gain as of midday Jan. 4.
So, what’s responsible for the continued whiplash? The same host of issues that plagued investors through much of last month, Eibel said. “From a market perspective, it’s essentially December 35th,” he quipped, “as trade talks between the U.S. and China, U.S. Federal Reserve monetary policy, the partial government shutdown in the U.S. and the Brexit saga continue to hound markets.” In other words, there’s a tremendous amount of information for markets to process, he said. Projections of a slowdown in the U.S. economy—Eibel and the team of Russell Investments strategists expect GDP (gross domestic product) growth of roughly 2.2% or 2.3% this year—only further compound matters, he added.
A tale of two reports: Strong employment gains and weaker manufacturing numbers in U.S.
The December employment report for the U.S., released Jan. 4 by the Bureau of Labor Statistics, is a perfect example of the difficulties markets are having getting a read on the state of the economic landscape, Eibel said. The country added 312,000 jobs last month—a very strong number that was significantly higher than consensus expectations, he noted. On the other hand, the Institute for Supply Management’s index, which gauges manufacturing activity in the U.S., showed a notable slowdown in December, Eibel said—consistent with lower numbers in Europe and China.
“Conflicting signals like these are what the market is going to be processing going forward,” he stated. So, what could make the market lean more in either direction—up or down—in the weeks ahead? Earnings season, Eibel said.
Q4 earnings season projections
Eibel and the team of Russell Investments strategists anticipate that fourth-quarter earnings in the U.S. will come in around 10% or a little higher. “On an absolute basis, that’s a nice year-over-year growth,” Eibel remarked, “but the market is likely to view this in comparison to the 20% to 25% earnings growth experienced during the third quarter of 2018.” In addition, moving forward, quarterly earnings—when compared on a year-over-year basis—will become more of an apples-to-apples comparison, Eibel said, as the impact of the December 2017 tax reform bill will be reflected in both numbers.
“The key issue that markets will probably be looking at as reports start trickling in is what companies are saying about their revenue,” he said, noting that decreased revenue projections from Apple for the first quarter of 2019 sent stocks tumbling on Jan. 3.
All told, Eibel believes that markets are likely to remain volatile in the weeks ahead, which may help make the case for a globally diversified portfolio. “Right now, we’re seeing different asset classes perform differently at different times,” he concluded, “and this looks to continue for the foreseeable future.”
Wild market swings: New index highs and steep drops. Fiscal stimulus. Retirement concerns. Yield curve worries. Trade wars and tariffs. 2018 seemingly had it all—and so did our blog, which addressed a wide array of the year’s hot-button issues, establishing new readership records in the process. As 2018 draws to a close, take a look back with us at our top ten favorite blog posts of the year—the thought leadership pieces that sparked the highest levels of engagement among our readers.
Fiscal stimulus in the U.S. and tariffs imposed by the Trump administration make today’s late-cycle bull market stand apart from previous ones. Our chief investment strategist, Erik Ristuben, explores whether this means a different ending may be in store as well.
Helping advisors reach their goals by focusing on outcomes—rather than some short-term benchmark—is the only true measurement of success, says Mark Spina, head of advisor and intermediary solutions for North America.
Our director of client strategy and research, Justin Owens, goes deep on what made 2017 a record-smashing year for contributions and investment earnings among the largest U.S.-listed defined-benefit plan sponsors.
Is the clock running out on one of the longest economic expansions in U.S. history? In this post, Senior Investment Strategist Paul Eitelman assesses the risk of a U.S. recession over the next 12 months by evaluating economic growth factors, corporate debt levels, the state of the labor market and U.S. Federal Reserve policy.
What do advisors need to do in order to deliver value beyond the fee or commission they charge? Focus on planning, prioritization, portfolio alignment and personalization, says Brad Jung, North America’s managing director of sales for advisor and intermediary solutions.
The current trajectory toward an inverted U.S. Treasury yield curve has potential recessionary implications, says Kevin Turner, managing director and global head of client strategy and research. Why? Historically, one of the more reliable precursors of recessions has been the slope of the yield curve.
With speculation over when the next bear market will kick in on the rise, Senior Portfolio Manager David Vickers discusses the difficulties of predicting stock market downturns, while offering up four watchpoints that could help fuel the next crash.
Helping clients invest smartly around taxes is an excellent way for advisors to differentiate themselves, explains Frank Pape, senior director of our portfolio consulting group for advisor and intermediary solutions. While most advisors focus on the impact of taxes to individuals and families, taxable trusts are an additional area where new clients can be gained, he says.
A new study suggests that earning wealth through the stock market may be better accomplished by focusing on slow and steady long-term growth, rather than chasing top-tier performance. Portfolio Analyst Stella Liu explains why the findings of this research are more important than ever amid today’s market backdrop.
On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Research Analyst Brian Yadao discussed market reaction to the U.S. Federal Reserve (the Fed)’s latest interest-rate increase, the impacts of a potential U.S. government shutdown on markets and volatility projections for 2019.
Markets sink in wake of Powell press conference
In a widely-anticipated move, the Fed announced another interest-rate hike on Dec. 19, raising the benchmark lending rate to a target range of 2.25% to 2.50%. Market reaction was initially fairly muted, but remarks by Chair Jerome Powell during a follow-up press conference quickly sent stocks tumbling. Why?
“Responding to a question about quantitative tightening, Powell said that the Fed’s balance sheet runoff is on autopilot—and that really seemed to spook investors,” Ristuben said, adding that he found the strong reaction somewhat surprising. “Both Powell and former Fed Chair Janet Yellen have previously talked about shrinking the balance sheet (by up to $50 billion a month) in automatic fashion,” he noted.
Powell’s comments probably touched on a primary issue for markets, Ristuben said: concern that the Fed is striking too hawkish of a tone at a time when the growth of the U.S. economy and corporate earnings appear primed for a slowdown. “At Russell Investments, we anticipate that GDP (gross domestic product) growth rates will slow from roughly 3% this year to closer to 2% in 2019, as the impacts of tax cuts and fiscal stimulus fade.” Earnings growth among U.S. companies, Ristuben believes, will probably lower to somewhere in the single-digits—a big drop from the roughly 25% growth rates observed earlier this year.
“At the end of the day, the market is really struggling over whether or not 2019’s forecasted slowdown will be the start of a recession,” he said, “and that’s made it extra-sensitive to all kinds of news.”
Impacts of a U.S. government shutdown on markets
With a partial shutdown of the U.S. government a possibility beginning Dec. 22, markets are likely to experience a renewed dose of volatility, Ristuben said. However, he emphasized that, in the end, a shutdown is unlikely to have a lasting impact. “What the market really cares about most is how the U.S. economy is holding up, versus any headlines coming out of Washington, D.C.,” he remarked. With a divided U.S. government looming come January, shutdowns may also become more common going forward, Ristuben noted.
2019 outlook: More volatility ahead?
The week of Dec. 17 was a particularly bad one for equities, especially in the U.S., Ristuben noted, with the Russell 1000® Index dropping nearly 7% on the week (as of mid-morning Pacific time, Dec. 21). By contrast, in the same timeframe, the MSCI EAFE Index—which measures the performance of developed markets outside of the U.S. and Canada—was down only 3.3%, while the Russell Emerging Markets Index was off approximately 2.3%.
“This shows that the weakness in the stock market is really about the U.S.—and increasingly, about recession risks in particular,” Ristuben explained, “as the current U.S. economic expansion is just over six months away from becoming the longest on record.”
So, how might 2019 unfold? “It will likely be a year marked by plenty of market volatility and smaller returns,” he said, emphasizing that a cautionary approach may be the way to go.
Markets hit the rewind button this afternoon as the U.S. Federal Reserve (the Fed) talked about the need for “some” further rate hikes in 2019.
While the Fed raised interest rates again today by 25 basis points, Chair Jerome Powell reiterated that the central bank will adopt a data-dependent approach when it comes to weighing future rate hikes going forward. Major indexes, which had stumbled to their worst December start since the Great Depression1, were rallying this morning in anticipation of a more dovish outcome, but have since given up all of those gains and then some. The S&P 500® Index fell over 1.5% to 2,506, while the Dow Jones Industrial Average sank over 350 points to 23,323—both hitting new lows for the year.
In our view, the Fed threaded the needle today—raising rates and forecasting “some” further hikes, but marking down the anticipated number of rate increases for next year from three to two as concerns over the health of the global economy and financial markets have grown.
Today’s rate hike, the fourth of 2018, means that the Fed has now—somewhat boringly—taken tightening steps at every quarterly press conference meeting dating back to December 2016.
Those decisions, in our view, have been well justified. At the risk of oversimplifying U.S. monetary policy, Chair Jerome Powell really appears to only care about two things:
First, he wants U.S. workers to have jobs. With the unemployment rate hovering around a 49-year low, Powell should feel pretty good about the full employment component of his dual mandate.
Second, he wants to make sure the economy doesn’t overheat (translation: keep inflation stable at around 2%). The next batch of core personal consumption expenditures (PCE) inflation data will be released this Friday. Our expectation is that it will come in at 1.9% on a year-over-year Admittedly, that’s a smidgeon below the central bank’s price stability target, but for all practical purposes, inflation is where the Fed wants it to be as well.
For a U.S. central banker, satisfying both of these mandates pretty much means mission accomplished. The Fed’s goal now becomes keeping the economy right here, forever (good luck!). How?
Establishing the neutral rate
Most policy rules will tell the Fed it should set its interest rate at a level that is neither restrictive nor accommodative for economic growth. Economists call this interest rate r-star, or the neutral rate of interest. The problem is that nobody knows where r-star is. The Fed has an informed guess about it—back in November, Powell said that rates are “just below the broad range of estimates of … neutral.” The Fed’s latest projections put this neutral interest rate at somewhere between 2.5% and 3% in nominal terms. We’d tend to agree. The current Fed funds target range of 2.25% to 2.5% is still slightly below neutral. As such, we think the next hike (probably in March) to get rates up into the neutral zone should be relatively easy. The decisions from there get a lot more interesting.
The Fed has transitioned its guidance on rates as we approach that point. In September, a large majority of FOMC participants advocated for a restrictive monetary policy setting (hiking beyond neutral). In November, the FOMC instead emphasized a flexible and data-dependent approach when considering further rate increases. Jerome Powell reinforced that tone in his press conference today. To be clear, data dependence does not mean dovish—it means that monetary policy decisions will be guided by data. In other words, if numbers from the first quarter of 2019 indicate a sharp slowdown in growth, the Fed is more likely to use this data as justification to hit pause on its interest-rate increases come June. On the flip side, if the data indicates a pickup in inflation, the Fed may use that to justify the need for further rate hikes.
U.S. growth and inflation outlook for 2019
Against this backdrop, the outlook for U.S. growth and inflation will prove pivotal for the Fed’s decisions in the new year. On the growth side of the ledger, incoming data continues to come in well ahead of the U.S. economy’s long-term potential (see first three rows in the table below). Put differently, there appears to be a significant cushion for a moderation in economic growth rates before the Fed should consider pausing. The slowing of global growth and the tightening of financial conditions are risks in this regard—but solely through their impact on domestic fundamentals. We believe that for now, the damage has not been severe enough to call into question the tightening cycle.
The inflation outlook is more uncertain. As noted above, our expectation is for core PCE inflation to log in at 1.9% for November—a tenth of a percentage point below the Fed’s target. We believe that a case can certainly be made for the Fed to wait for greater evidence that inflation is breaching its 2% inflation target before transitioning to a restrictive monetary policy setting.
Why? There are several cross-currents buffeting U.S. inflation.
On the downside:
Recent dollar strength is likely to prove disinflationary in early 2019 as it lowers the price of imported goods;
The sharp decline in crude oil prices is a headwind;
Perhaps most importantly, the U.S. housing market and rental price inflation show some early signs of slowing as higher mortgage rates have dented affordability for would-be new buyers.
On the upside:
The labor market is historically tight;
This is (finally) translating into accelerating wage inflation (see chart below);
Producer prices are picking up; and
Measures of output prices in the business surveys are generally inflecting higher as well.
Source: Bureau of Labor Statistics, Federal Reserve Bank of Atlanta. Data as of November 2018.
While the verdict is not clear-cut, the balance of evidence in our view points to inflationary pressures gradually building as we get later in the U.S. cycle. Put differently, with growth comfortably above trend and with inflation creeping higher, the balance of evidence suggests the Fed will need to hike beyond March.
Key investment takeaways
From an investment strategy perspective, this is important because fed fund futures are now pricing less than one hike through the end of 2019. To reiterate our view: we think the next hike to get rates into the neutral zone will be relatively easy. And while we’d note the outlook from there is more uncertain, we see the balance of risks as being skewed to further hikes. The gap between our view on the likely path of Fed policy and what is priced into fixed-income markets is currently at its widest since August of 2017.
Cyclically, we see potential for higher 10-year U.S. Treasury yields over the next six months. From a sentiment perspective, investor positioning has also normalized. Speculators were overwhelmingly betting on rising rates three months ago. We find speculative positioning to be a powerful contrarian indicator. A few months ago, that indicator was advocating for us to express an overweight preference for U.S. Treasuries. It has now been neutralized. From a valuation perspective, 10-year Treasury yields have transitioned from being slightly cheap (3.25%) in November to now being within the vicinity of our 2.6% fair-value estimate.
Our cycle, valuation and sentiment framework suggests upside risk to Treasury yields over the next six months. Tactically, we see an opportunity to trim allocations to risk-avoiding fixed income and other rate-sensitive assets.
On the latest edition of Market Week in Review, Senior Quantitative Investment Strategy Analyst Dr. Kara Ng and Rob Cittadini, director, Americas institutional, discussed U.S. recession risks, the potential benefits of portfolio diversification in an economic downturn and the latest developments in the ongoing Brexit saga.
Recession worries on the rise as stock market slump continues
The ongoing slide in U.S. equities (as of market close Dec. 14, the S&P 500® Index is down 2.75% on the year, while the Dow Jones Industrial Average is off 2.5% for 2018), coupled with the pronounced recent flattening of the U.S. Treasury yield curve, has led to increased speculation about the potential timing and severity of the next U.S. recession. Ng and the team of Russell Investments strategists believe that late 2019 into 2020 is the most likely timeframe for an economic downturn to set in. Why?
“U.S. GDP (gross domestic product) growth, the labor market and consumer spending are still very strong—implying that near-term recessions risks remain relatively low,” she said. However, Ng expects that the risks of a recession will become elevated later in 2019 as the impacts of fiscal stimulus—which helped boost U.S. GDP growth and corporate earnings in 2018—fade around the midpoint of next year. In addition, accelerating wage growth and a tight job market likely mean that the U.S. Federal Reserve will continue raising interest rates into 2019, she said. “This could lead to an inversion of the yield curve—and historically, once the yield curve inverts, a U.S. recession follows within 12 months,” Ng noted.
However, she emphasized that the next recession in the U.S. is likely to be fairly mild—probably more on par with the economic downturn of 2001 than the Great Recession.
Weathering the storm: Potential benefits of diversification in a bear market
Generally speaking, a broadly diversified, multi-asset portfolio may help investors better weather the next bear market, Ng said. “Within equities, defensive sectors like consumer staples and healthcare tend to fare better during market downturns,” she noted. In addition, analysis by Ng and the team of Russell Investments strategists of the last several market cycles indicates that adopting a defensive portfolio strategy earlier on is generally less painful than waiting until after a bear market sets in.
“Another interesting tidbit we uncovered in our research is that having cheap valuations heading into a downturn tends to be associated with a smaller overall portfolio drawdown,” she stated. What this likely means is that, although the next recession may be mild, U.S. equities are at heightened risk for a steeper pullback, due to their expensive valuations, Ng concluded.
More market volatility likely in UK as Brexit drama continues
Turning to Brexit, Ng noted that the political rollercoaster over the UK’s divorce from the European Union continued the week of Dec. 10, punctuated by Prime Minister Theresa’s May survival of a no-confidence vote. “Because the revolt against May failed, she’s free from another challenge to her leadership for 12 months,” Ng noted, “but make no mistake, her position of authority has been severely weakened.”
So, what might happen next? “We think the majority of Parliament still wants to avoid a no-deal Brexit,” Ng said, “but it just so happens that at the moment, they can’t decide what they alternatively want.” As a result, UK bond yields and sterling will probably remain volatile as the saga continues, she said.
Does the U.S. Treasury yield curve always foretell a recession?
With the spread between 10-year and 2-year Treasury yields down to just 13 basis points1, an active debate is raging among economists about the efficacy of the yield curve as a recession indicator in the current cycle. Historically, an inverted yield curve is a tell-tale sign of a looming economic downturn—and markets have certainly taken note lately, with the Dow Jones Industrial Average and the S&P 500® Index both tumbling approximately 4% last week as the spread between yields sharply narrowed.
With prevailing trends pointing toward continued flattening, it’s quite possible that an inversion of the curve could occur early next year. If this happens, history tells us that the U.S. economy could be at heightened risk of a recession in late 2019 / 2020. This is a warning signal that we believe should be taken seriously. To understand why, let’s delve into exactly what an inverted yield curve means.
Why economists use the curve as a leading indicator
Conceptually, an inverted yield curve tells us that the stance of monetary policy is transitioning into restrictive territory. In very simple terms, the U.S. Federal Reserve (the Fed) controls the short (overnight) rate, and the market prices the long (10-year) rate based on its view of trend growth. Therefore, when the curve inverts, it signals the Fed has moved short rates above what the economy can sustain in the long run. With monetary policy acting as a hindrance to growth, a recession becomes more likely.
Empirically, an inverted curve has been the single best leading indicator economists have for modelling recessions. Indeed, every recession in the last 60 years was preceded by an inverted curve.2
Term spread versus term premium
You’ll note that we use the phrases slope of the yield curve and term spread interchangeably to refer to the difference between long-term and short-term Treasury yields. For example, the 10-year / 2-year term spread is currently 13 basis points (as of Dec. 7). In other words, it’s a 2.85% yield on the 10-year Treasury note minus a 2.72% yield on the 2-year Treasury note.
The bulk of the academic debate around the efficacy of the yield curve currently surrounds the notion of the term premium. It’s important to note that a term premium is distinct from a term spread. This is because Treasury yields at any tenor can be broken down into two pieces:
The average expected short-term interest rate over the life of the bond (often referred to as the risk neutral yield), plus
A risk premium (or term premium) that compensates investors for the possibility that the actual path of short-term interest rates deviates from those expectations.
Term premia cannot be directly observed. Instead they are estimated with term structure models.
Some of the arguments today center on the idea that the yield curve is flatter than otherwise would be the case because of unusually low term premia—the implication from this being that an inversion may prematurely signal recession risk relative to the historical experience.
Let’s take a closer look at this argument.
Don’t fear the yield curve
“Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not,” because the normal market signals have been distorted by, “regulatory changes and quantitative easing in other jurisdictions…everything we see in terms of the near-term outlook for the economy is quite strong.”
–Former U.S. Fed Chair Ben Bernanke, July 2018
“I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed…the fact the term premium is so low and the yield curve is generally flatter is an important factor to consider.”
–Former U.S. Fed Chair Janet Yellen’s final press conference, December 2017
These arguments are effectively saying that global quantitative easing (QE) leads to lower long-term U.S. interest rates—and that this will lead to a premature inversion that has little to do with U.S. fundamentals or the risk of recession. Conceptually, we believe the logic behind this is sound.
Based, in part, on this motivation, two staff economists at the Federal Reserve Board in Washington, D.C., recently published a note, entitled “(Don’t fear) the yield curve”. Their paper argues that, instead of the standard term spread, we should be looking at the 0-to-6 quarter near-term forward spread. In essence, this alternative indicator measures whether the market is pricing the Fed to cut rates over the next 18 months (something that usually happens in response to a recession). They argue that this indicator (blue line below) is more intuitive, and they find that it statistically dominates the standard term spread when both indicators are included in a predictive model for recessions. We have a few concerns with this piece:
We believe the intuition from term spread to policy stance to recession risk is straightforward. The question is more about whether term premia are distorting that message right now.
In the authors’ own words “the near-term spread may only predict recessions because it impounds expectations that market participants have already formed” …
…and to the extent these expectations are embedded in asset prices already (in a probabilistic sense), the near-term spread isn’t particularly helpful in formulating a forward-looking investment strategy.
Source: Russell Investments calculations, Thomson Reuters Datastream, Bloomberg. As of December 4, 2018.
That said, we do believe this study cannot simply be ignored—and as such, we’ve added the 0-to-6 quarter forward spread to our late cycle dashboard. We do, however, have a few reservations with using it as a major pillar of our market outlook.
Fear the yield curve
Economists at the Federal Reserve Bank of San Francisco recently tackled many of the counterarguments to this in an empirical piece titled “Economic forecasts with the yield curve”. They used models to control for the fact that the absolute level of interest rates is much lower today than it has been in the past, and they decomposed the term spread into the expectations component of the path for short rates and the term premium. In all cases they concluded that the predictive power of the term spread remains intact. Their conclusion:
“While these hypotheses have some intuitive appeal, our analysis shows that they are not substantiated by a statistical analysis that incorporates the suggested factors into the type of predictive models we use. For example, including both a short-term and long-term interest rate in such models—and thereby allowing the level of interest rates to have a separate effect from that of the term spread—shows that only the difference between these interest rates, the term spread, matters for recession predictions. Separating the term spread into risk premium and expectations components does not improve the forecast beyond using only the term spread…these findings indicate concerns about the scenario of an inverting yield curve. Any forecasts that include such a scenario as the most likely outcome carry the risk that an economic slowdown might follow soon thereafter.”
Obviously, there is risk in taking the results from a statistical analysis above the economic intuition of two former Fed chairs, but at the very least this stresses to us the importance of taking an inversion seriously from a risk management perspective in portfolios.
We can also check the signal from the curve by looking at the stance of U.S. monetary policy from other angles. The chart below plots the federal funds rate against our preferred estimate of the neutral rate of interest, and shows that U.S. monetary policy is getting very close to the point at which it turns restrictive. This is entirely consistent with the Federal Open Market Committee (FOMC)’s own discussions as detailed in its minutes from August.
Source: Thomson Reuters Datastream, Q2 2018
We’d also highlight the cautionary tales of economists mistakenly using the this time is different argument with the yield curve in the past. For instance, Bernanke, who is in the don’t fear camp today, made a very similar argument about low term premia back in 2006. In 2006, the story was about excess global savings and Chinese demand for Treasuries (rather than the impacts from global QE, which is his argument today). But the conceptual underpinnings for his optimism in 2006—i.e., don’t worry—were similar to what he is basing his views on again today.
Ultimately, we believe that the conclusion reached by Federal Reserve economists Glen Rudebusch and John Williams in a 2008 research paper3 still rings true today:
“For over two decades, researchers have provided evidence that the yield curve, specifically the spread between long- and short-term interest rates, contains useful information for signaling future recessions. Despite these findings, forecasters appear to have generally placed too little weight on the yield spread when projecting declines in the aggregate economy. Indeed, we show that professional forecasters appear worse at predicting recessions a few quarters ahead than a simple real-time forecasting model that is based on the yield spread.”
On the latest edition of Market Week in Review, Mark Eibel, director, client investment strategies, and Consulting Director Sophie Antal Gilbert discussed the impact of the U.S.-China trade truce on markets, the flattening of the U.S. Treasury yield curve and November’s U.S. employment report.
Wild week for markets in wake of trade-war ceasefire
At a Dec.1 meeting in Argentina, the U.S. and China agreed to refrain from increasing tariffs on each other’s imports for a period of 90 days. Markets initially rose on the news, with the Dow Jones Industrial Average climbing 287 points on Dec. 3, while the S&P 500® Index finished that day up approximately 1%. “That seems so long ago,” Eibel remarked, “as it’s been quite the wild ride ever since.” Major indexes plunged the following day, Dec. 4, as contradictory reports on the details of the trade-war ceasefire and the progression of the trade talks emerged from both sides. “Dec. 4 appears to have been when reality set in for markets,“ Eibel said, “leading to choppiness that accelerated the rest of the week as the U.S. Treasury yield curve sharply flattened.”
Recession worries rise as yield curve flattens
The yield on the benchmark 10-year U.S. Treasury note dropped dramatically the week of Dec. 3, Eibel said, falling from nearly 3% at the start of the week to 2.85% by mid-week. With the yield on the 2-year Treasury note also decreasing to around 2.75%, the spread between long and short-term yields narrowed considerably—to as low as 11 basis points on Dec. 4.
“Over the last 50 years, every time the yield curve has inverted, there’s been a recession in the U.S. no more than 12 months later,” Eibel said, “which is why markets sold off as the curve flattened.” What really put the market on edge, he added, was that the yield on the 5-year Treasury note at one point dropped below that of the 3-year Treasury note—a momentary inversion. “While most economists define a yield curve inversion as occurring when the 10-year yield falls below the 2-year yield, this did mark the first time in quite a while that we’ve seen a shorter maturity have a higher yield,” Eibel explained. This, in his opinion, led to heightened market worries about when the difference between the 10-year and 2-year yield will become negative.
Eibel and the team of Russell Investments strategists believe the yield curve will probably continue to flatten as the month progresses. Why? The U.S. Federal Reserve (the Fed) is likely to increase interest rates at its Dec. 18-19 meeting, he said—and this should drive up the yield on the 2-year note. Meanwhile, worries over slowing economic growth are leading to downward pressure on the 10-year note, Eibel remarked. In addition, he added, economic expectations and inflation both influence the slope of the curve—and both of these factors will likely be somewhat driven by the outcome of the U.S.-China trade situation.
November employment report: Wage gains unchanged as U.S. adds 155,000 jobs
On Dec. 7, the U.S. Bureau of Labor Statistics unveiled the country’s employment report for November, Eibel said. “The key highlight in the report is that there is no key highlight,” he quipped, explaining that the U.S. added 155,000 jobs, while the unemployment rate remained steady at 3.7%. Average hourly pay, which has garnered increasing attention this year, also matched October’s year-over-year increase at 3.1%, Eibel noted.
“These numbers are some of the last real data points to be released prior to the Fed’s upcoming meeting—and I think they won’t alter the central bank’s decision on a final rate increase for 2018,” he stated. In his opinion, it’s highly likely that the Fed will raise interest rates later this month—as the numbers appear to confirm that there’s probably still enough strength in the U.S. economy to justify a hike. “The real focus, in my view, is what the Fed does at its March 2019 meeting,” Eibel stated, concluding that he and the team of Russell Investments strategists believe there’s an above-average probability that the central bank will raise rates then as well.
U.S. Federal Reserve tightening, trade wars, China uncertainty, Italy’s budget standoff with the European Commission and Brexit imply that 2018’s volatility should continue into 2019. We believe that 2020 marks the danger zone for a U.S. recession, which gives equity markets some upside in the year ahead. However, late-cycle risks are rising—and monitoring these risks will be critical to avoid buying a dip that turns into a prolonged slide.
2019 Global Market Outlook: The late-late cycle show - YouTube
Key market themes
We believe 2019 will feature volatile equity markets that deliver mid-single-digit returns, with better potential in Europe and Japan than the U.S. We have an underweight preference for U.S. equities, mostly driven by expensive valuations. The market cycle is broadly neutral but is likely to be under downward pressure later in 2019. The sell-off in late 2018 has triggered some contrarian oversold signals, so there is scope for a tactical bounce. We expect the U.S. Federal Reserve (the Fed) to follow its December rate rise with three to four additional hikes in 2019, which will probably lead to an inversion of the U.S. Treasury yield curve.
In eurozone equity markets, we expect 8% growth in earnings per share in 2019, which would be a positive outcome for investors relative to what they have experienced over the past two decades. To achieve that profit increase, eurozone gross domestic product (GDP) growth needs to stay at or slightly above the long-run potential of around 1.5%, which we think is very achievable. The main risks to the benign cycle view are the budget conflict between Italy and the European Union, a disorderly Brexit and an escalation of the global trade war. Our base case is for these three risks to fade during the course of 2019.
As UK equities have effectively traded sideways over 2018, they continue to look slightly cheap on our scorecard moving forward. At 1.4%, 10-year gilts are still long-term expensive, and indeed more expensive now than this time last quarter given our higher forecast for the UK base rate.
In Asia Pacific, we foresee another solid year. We expect emerging Asia to deliver over 10% in earnings growth, while we view Japan as well-placed to exceed modest industry consensus expectations. Across the region, we think valuations are fair to attractive. Japanese and Chinese equities stand out as attractive, while Australian equities are close to fair. With inflation and wages gradually rising in Australia, and the labor market at full employment, we think the Reserve Bank of Australia will have the scope to raise rates once in 2019.
We see the downturn in Canadian commodity prices, led by oil in particular, as an ominous sign for future earnings growth. However, the cycle is still modestly positive and relative value is encouraging. Overall, we are slightly positive on Canadian equities, especially relative to U.S. equities, due to the sizeable valuation and yield advantage.
An important reason for the strength in the U.S. economy and corporate earnings in 2018 has been the Trump administration’s fiscal stimulus. We believe that the peak economic boost from the fiscal stimulus will last into early 2019, before it becomes a drag on the economy in 2020.
The current U.S. expansion will become the longest on record if it continues to July 2019, which seems likely. That said, we believe U.S. GDP and corporate profit growth will slow, while inflation pressures build.
Japan and Europe aren’t likely to grow faster than the U.S. in 2019, but we believe they have the potential to outperform pessimistic expectations.
China’s economy is on track for GDP growth of around 6.5% in 2018, its slowest since 1990. It faces headwinds from high indebtedness, slowing property construction, poor demographics and the trade war with the U.S. As a result, fiscal stimulus is underway, which should be enough to keep growth near 6% in 2019.
Asset class views
Equities: Broadly neutral
Our cycle, value and sentiment investment process results in an overall neutral view on global equities. While we are underweight U.S. equities, we’re more positive on non-U.S. developed equities. We like the value offered by emerging markets equities, but the threat of trade wars, slowing economic growth in China and further U.S. dollar strength keeps us at a neutral allocation. A stronger contrarian sentiment signal that investors are turning negative on emerging markets would be a reason to increase allocations.
Fixed income: Fair value at 2.7% in the U.S.
We like the value offered by U.S. Treasuries. Our models give a fair-value yield of 2.7% for the U.S. 10-year bond. We see German, Japanese and UK bonds as very expensive, with yields well below fair-value. The cycle is a headwind for all bond markets as inflation pressures build and central banks tighten further, such as the Fed and Bank of England, or move away from extreme stimulus, such as the European Central Bank and Bank of Japan (BOJ). High yield credit is expensive and losing cycle support, as is typical late in the cycle, when profit growth slows and there are concerns about defaults.
Currencies: Preference for Japanese yen
The yen is our preferred currency. It’s significantly undervalued, getting cycle support as the BOJ becomes less dovish and has contrarian sentiment support from extreme market short positions.
The euro and British sterling appear undervalued as we move into 2019. The recovery in European economic indicators should support the euro. Sterling will be volatile around the Brexit negotiations, but should rebound if a deal is agreed with the European Union. We think it has more upside potential than the euro. We also believe that the U.S. dollar has modest upside potential.
At the 2018 G-20 Buenos Aires summit that concluded last weekend in Argentina, U.S. President Donald Trump and Chinese President Xi Jinping agreed not to impose any new tariffs for three months to allow negotiations to continue at the technocrat level. This ceasefire delays the ramp up in the U.S. tariff rate from 10% to 25% that was scheduled for the Jan. 1 (impacting $200 billion of Chinese imports). The agreement stalls Trump’s threat of new tariffs against the final $267 billion of imports from China, at least temporarily. In response, China “will agree to purchase a not yet agreed upon, but very substantial”1 amount of U.S. exports.
A positive turn in the trade war
This is a positive turn in the trade war, but it falls close to the consensus expectations from economists. A more positive outcome would have contained substantive details and/or a longer pause (e.g., six months). The three-month ceasefire by no means guarantees that a final trade deal will be struck, but it improves the risk distribution for markets.
Impact on global equities
We view the G-20 meeting as a small tailwind for global equities, with the order of impact being most positive for China and emerging markets (EM) and least positive for the U.S. This ceasefire is probably not long enough to meaningfully reduce uncertainty for the CEOs (chief executive officers) of multinational businesses. Therefore, we expect U.S. (and global) capital expenditure to remain subdued until a lasting agreement is reached.
Until very recently, there has been little discernible impact from the trade war onto our high frequency business confidence tracker. In the November regional U.S. Federal Reserve (Fed) surveys, however, we saw a marked stepdown in the optimism of U.S. manufacturing executives. It’s difficult to disentangle how much of this was from lingering trade concerns versus the moderation in global growth rates and the collapse in crude oil prices—but we suspect the latter forces are playing a more significant role.
Where next for stabilization?
The next Beige Book report from the Fed, scheduled for release on Dec. 5, will give us a cleaner read on the underlying narrative. At present, we expect there to be a stabilization/rally in oil, a stabilization/reacceleration in Europe and Japan as well as a stabilization in China. Given this, we look for our confidence tracker (and other broader indices like the Institute for Supply Management Index—i.e., the ISM Index) to stabilize firmly in the zone consistent with positive above-trend economic growth. The sharpness of the recent dynamic bears a watchful eye, though.
Source: U.S. Federal Reserve System and Russell Investments calculations, as of 30 November 2018.
Implications for U.S. tariffs
The implications of U.S. tariffs are more material to the inflation outlook. The tariffs that have already been implemented ($50 billion at a 25% rate, and $200 billion at a 10% rate) are currently adding roughly 0.1% to core personal consumption expenditures (PCE) inflation. With the 90-day pause for further negotiations, we’ve pushed back our timeline on the expected inflationary impacts from the higher tariff rate by three months. The bottom line is that the near-term inflationary consequences of protectionism are still potentially very significant, but the pause means they are more likely to show up in mid/late 2019 now (if at all).
Implications for the Fed
The implications for the Fed are mixed. The first order effect is that the ceasefire removes a near-term event risk for the December and March Federal Open Market Committee (FOMC) meetings, making hikes marginally more likely on each of these dates (where we already had high conviction levels). Easier financial conditions, should they emerge, would also be a tailwind for the Fed’s ability to deliver on its intended rate hike path. The recent weakness in core PCE inflation, however, coupled with the delay in potential tariff-related inflation boosts, does suggest some potential for a Fed pause scenario in June. To be clear, this is not our baseline view. As we can see in the chart, the inflationary consequences of tariffs are transitory—meaning the Fed is likely to look through them. Our expectation of continued above-trend U.S. economic and employment growth should continue putting pressure on a very tight U.S. labor market. Furthermore, our team expects an abatement of the downside risks emanating from non-U.S. growth.
Impact on Chinese GDP
From a Chinese economy perspective, the Xi/Trump meeting in early December was a touch better than our expectations. In terms of economic implications, there’s nothing here to change our expectation of a moderate-risk slowdown in the Chinese economy in 2019, from 6.5% gross domestic product (GDP) growth to 6.0% GDP growth.2 While the uncertainty around such estimates is always high, we believe it’s convenient to calibrate and track the China impact of the trade war in terms of GDP impact. The best outcome we see would be a one-off permanent reduction of Chinese real GDP by 0.5%. The worst outcome, from our vantage point, would be a negative GDP hit of 1.5%, which we would associate with a high to very high-risk slowdown. As of today, we anticipate that there will be a 0.75% real GDP hit.
Implications for the trade war
We’d rate the outcome of the weekend’s talks as one-part trade war, one-part grandstanding and one-part obfuscation. And maybe even some progress. That’s a whole lot better than three parts trade war. Even getting a communique was not necessarily expected. At present, we are overweight China A-shares and will be staying this way for now.
Given that within the U.S., Trump’s main objective appears to be seen as reprimanding China, while within China, Xi’s main objective (incompatibly) appears to be seen as standing up to the U.S. and giving no ground—then an unclear meeting outcome that kicks the can down the road and that nobody can understand, is a win for global investors.
All of that said, we’d adhere to a view that the U.S. and China will be oscillating between fake deals and fake unilateral initiatives, through much of 2019. That, in and of itself, makes so called muddle-through scenarios the most likely. These trade negotiations likely still have a long way to go. We’ll be watching the Chinese high-frequency economic indicators, and data from exports and the purchasing managers indices (PMIs), for an ongoing read on the impact.