Head of Fixed Interest Research
How long can an economic expansion last? It’s a key question for US investors, who are currently enjoying one of the longest periods of uninterrupted growth on record. But for some, there are unsettling signs about the health of economic growth, with recession signals like the US yield curve now flashing amber.
When the yield curve inverts (i.e. when long-term government bond yields fall below short-term yields), a recession is typically 24 months away. While the yield curve is one of the most accurate recession predictors, there are several reasons why it might not be a good idea to immediately sell shares.
Perhaps surprisingly, stock markets still tend to deliver positive returns following an inversion in the yield curve. US stocks have historically delivered a return of 14% in the twenty four months following an inverted yield curve, with investors who sold early often missing out.
And although the yield curve has historically proven accurate, it may be less valuable as a forward looking indicator nowadays. The yield curve is only accurate because it reflects where investors are happy to park their money – investors don’t want to buy bonds if the economy is performing strongly.
In recent years, that signal from investors has been distorted. The Federal Reserve bought US government bonds to help stimulate the economy after the financial crisis, lowering long-term bond yields, and making it easier for the yield curve to invert. The Federal Reserve’s ‘artificial demand’ for US government debt might therefore be sending a false signal about the prospects for the economy.
The main weakness in US economic data concerns the manufacturing sector. US industrial production unexpectedly fell in April, and the ISM manufacturing index fell to its lowest level since late 2016.
While manufacturing tends to be a lead indicator for the economy, it is not a perfect. We saw a similar picture in late 2015 and early 2016 for example, when many industrial companies were hurt by a falling oil price. Weak industrial production today can partly be attributed to cold weather and trade tensions between the US and China. For the meantime, the customers of many manufacturers are drawing down their stockpiles, rather than buying new products and spending money they may need later on.
While there are clearly weaknesses in the manufacturing sector, consumer spending accounts for close to 70% of US GDP, making it by far the most important contribution by far.
On current data, the US consumer remains in robust health. Consumer confidence hit a fifteen year high in May, with low unemployment and gently rising wage growth leading to a modest improvement in consumer finances. While there are some signs of cooling consumer demand (such as in the amount people are spending on home improvements and decorating), these are very early signal indicators.
There are outside factors that could impact the US economy. An escalation in tensions between the US and Iran, for example, could threaten global oil supplies, pushing up oil prices. While this would probably be enough to tip the global economy into recession, it remains a speculative scenario.
The trade dispute between the US and China is the bigger concern. The prospects of a deal between the US and China fluctuate from week to week (and tweet to tweet), but both economies could probably cope with a rise in the tariffs.
While a recent report claimed the latest tariff increases could cost the average US household $831, they effectively function just like higher taxes or oil prices, the fluctuations of which investors are much more used to. China, meanwhile, has plenty of room to stimulate its economy, and has been doing so in recent months.
The bigger concern is the strategic rivalry between the US and China. The Trump administration added China’s leading technology company, Huawei, to a trade blacklist in mid-May. This makes it far more difficult for Huawei to do business with US companies. According to one consultancy, in the worst case scenario such a move could ‘put at risk both the company itself and the networks of Huawei customers around the world’. Alphabet, Google’s parent company has already started distancing itself from Huawei.
Standing in the way of a recession, however, is the upcoming 2020 US Presidential Election. While Donald Trump is an instinctive protectionist, he will want to be re-elected. This might ultimately help to contain any escalation in terms of tariffs, at least up until Election Night. Trump will also be inclined to keep the economy performing, potentially through higher government spending if needs be, or even pressuring the Federal Reserve to cut interest rates. The Fed is meant to be above politics, but pressure on the central bank has occurred before, most notably from Richard Nixon ahead of the 1972 election.
There is no doubt that the US economy has cooled from the strong rate of growth following Trump’s election victory. For the meantime, this looks like a moderation in growth rather than a recession. The yield curve does indicate that we could see a recession after the Presidential election, but it may be a less accurate indicator than in the past.
Some may be tempted to sell their shares now. While this is understandable, a better response might be to look at your asset allocation. Holding some safe haven assets such as US government bonds or gold can mitigate the impact of market falls, while allowing you to benefit from any ongoing rise in shares. The next recession is probably closer to us than the last one, but the case for staying invested remains strong.