The media is throwing out the recession word again. At first I thought ‘I wonder how much more viewers those media outlets get when there is panic and worry versus when things are good and people are enjoying life?’ The second thought I had was ‘too much first level thinking in the media.’
The big news that drove the recession talk was the yield curve inverting. What else? One metric is not enough to predict or worry about a recession. You might want to look at unemployment since layoffs could indicate a recession is coming. Employment is still strong in the U.S. How about housing starts (new house construction), which was down 4% in July but building permits were up 8% in the same month3? The panic button wasn’t those metrics but the yield curve inverting. We need to dig into this further before buying into the panic.
Yield curve inverting – which basically means the long-term interest rates (10 year) are lower than the short-term interest rates (2 year). In healthy economies, longer-term bonds have to pay higher yields in order to get investors to buy them. This is because if the economy is stable, interest rates are typically rising or at least staying flat. If interest rates are expected to rise, I am not buying a long-term bond unless the interest rate/yield is high enough to offset my expectations of higher shorter-term rates in the future. Would you buy a 6% 20 year bond if you expected interest rates to hit 6.5% in a year?
When the yield curve inverts, it TYPICALLY means that investors believe the economy is going to slow and interest rates are going to drop. If so, in theory, you would want to buy longer-term bonds and lock into higher rates. It is a mistake to assume that just because the yield curve inverted a recession is imminent, especially in the global environment we are in today. First, it is true every recession has been preceded by an inverted yield curve1 but not every inverted yield curve has led to a recession2. This is very important. Even more importantly, per a Credit Suisse study, on average it is 22 months later before the recession actually hits1. Thus, it is not a guarantee that a recession is upon us due to the inversion but even if it was, on average we are talking 22 plus months before it hits.
Another important point is how long the yield curve was inverted. Before the great recession of 2008, the yield curve actually inverted in 2005, 2 years before the recession4. It was also inverted for 2 years4. Meanwhile, in August of this year the yield curve inverted for ONE day. It is already back to not being inverted. The market sell-off, in my opinion, was a huge over-reaction to a temporary blip in the yield curve.
It is the very definition of over-simplification to try to predict a recession based on one metric. I like to follow 5 major indicators for recession concerns. They are:
- Yield Curve
- Housing Starts – currently questionable but a very favorable building permit increase is promising
- The ISM Manufacturing Index – declining but still positive
- Unemployment and Wage inflation – Employment is strong and wage inflation is still under the 4% benchmark I use
- Retail Sales – Still strong as the July figure came in at .07% growth versus expectations of .03%5
There are some concerns in our economy right now. As noted, housing starts are down and the ISM index is declining. The latter is not surprising with the trade war hanging over our head. Speaking of the trade war, there is a very short ceiling on any growth in the market or economy until it gets resolved. However, there is no reason to get overly concerned about a recession right now because several indicators are still strong. I still believe we are over a year away, if then, from a recession. What we don’t want to do is over-react to the media or let our biases drive our investing. Let the data talk. The data right now is telling me to be alert but not to take major action yet.
I hope this calmed some fears out there because the number of calls I have received regarding concerns over the market/economy has increased significantly. The most important point is our accounts lean towards the more conservative range within each category of Income, Growth and Income, or Growth. We do not believe this is a time to be overly aggressive but at the same time there is no reason for panic or to be overly concerned either.
- Credit Suisse, Aug 2019
- CNBC, “After a Key Yield Curve Inversion, Stocks Typically Have Another Year and a Half Before Doom Strikes” August 14, 2019
- CNBC, “Housing Starts Drop for Third Straight Month” August 16, 2019
- US Department of Treasury
- Trading Economics August 2019
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