“Winter is coming,” says Game of Thrones.
“Recession is coming,” says the US yield curve.
The only difference is that winter – the real-world winter, that is – always comes, at the same time.
Recession, its economic equivalent, is less predictable.
On the most widely-used definition – two consecutive quarters of shrinkage in gross domestic product (GDP), the value of all goods and services produced in the economy – the United States has not experienced recession since the period between the fourth quarter of 2007 and the second quarter of 2009, during which the US economy contracted by 4%.
Australia, famously, has not seen a recession since 1991: of the developed nations, only the Netherlands has avoided recession for longer than Australia.
Recessions represent the trough of the economic cycle, and as such, they usually cause a slump in the stock market – as can be seen in the accompanying chart, which shows the recession and stock market (S&P 500 index) slumps in the US since World War II.
The point is that recessions and stock market corrections (defined as a fall of 10% or more: a correction becomes a “bear market” when the fall exceeds 10%) are common occurrences, but not predictable. They both represent a “known known” in investment, meaning that investors must factor the prospects of each into their investment strategy, and monitor whether they are becoming more likely or less likely.
The chart tells us that since World War II, the average recession strips 1.9% from US GDP; and the average stock market sell-off takes 30% off the value of the stock market.
One of the most widely accepted warning signs is flashing red at the moment: the inversion of the US yield curve. When the interest rate on longer-term bonds actually falls below that of the shorter-term securities, it is seen by many observers as harbinger of an economic slump.
Last week – for the second time this year – the yield on 10-year US Treasury notes fell below the 3-month Treasury bill yield. It had done so in March, too, but only stayed there for a matter of days before the premium for longer-dated debt (the natural state) was restored.
What worried investors at the time was the March inversion was the first such event since 2007 – and we all know now what was coming down the track in 2007.
The US economy is actually showing signs of health at present: economic growth for the first quarter of 2019 was stronger than expected, at an annualised rate of 3.2%. That was considered a surprise given the headwinds the US economy faced: the ongoing trade tensions with China, a prolonged government shutdown, and global economic uncertainty.
The strength in US economic numbers continues to surprise. Consumer confidence rebounded quickly once the shutdown ended, and retail sales were robust in March: in fact, retail sales grew in March by 1.6%, their fastest growth rate since September 2017. For the year to March, US retail sales rose by 3.6%.
The jobs market is also posting strong numbers. After lagging expectations in February – when just 20,000 new jobs were initially reported – the US added 196,000 new jobs in March, while the number of Americans filing applications for unemployment benefits dropped in April to the lowest level in almost 50 years.
Those are not recessionary numbers, but investors have to ask themselves, what is the bond market worried about, given the two yield-curve inversions this year?
The US stock market appears blithely unconcerned, with all three major indices (Dow Jones Industrial Average, S&P 500 and Nasdaq Composite Index) either at, or close to, record highs, as many US companies have reported stronger-than- expected profits for the first (March) quarter.
Of course, investors should not take the insouciant current push to record highs as gospel: this mood comes less than six months after markets panicked in December, rattled by slowing global growth, continuing trade frictions between the US and China, perceptions that the US Federal Reserve was raising interest rates too quickly, US third-quarter economic growth being revised downward, and the unwelcome prospect of a US government shutdown. The 9% plunge in the S&P 500 in December (accompanied by an 8.6% drop in the Dow Jones and a 9.4% fall in the Nasdaq Composite) was almost the worst since the Great Depression of 1931.
The mood quickly turned around, as the Fed reversed course on rate rises and the prospects for agreement in the US-China trade talks improved, but that is the essential point – sentiment can change very quickly in the markets.
Which brings us back to – what is the bond market worried about?
It is worried about high debt levels (government and corporate), and the elevated default risk in the event of any economic slowdown. It is worried about the chances of a full-blown trade war between the US and China – just last week, the US upped the ante, lifting tariffs on about US$200 billion ($286 billion) in Chinese goods to 25%. It is worried about geopolitical tensions, and excessive share valuations in a late-cycle economy.
Should investors be worried? Well, they certainly should be armed with the knowledge that recessions and market slumps happen.
In a long-term investment holding period, an investor will likely experience multiple recessions and market contractions. But these periods pass.
Your investment strategy should always allow for what you do know about how economies and markets behave: there is no excuse, given recent history, for being blind- sided by a recession or a market slump. If you have a strategic asset allocation that progressively moves, through the cycle, to overweight cash and fixed income, and underweight market-linked assets – such that you can be confident that you ride out a market downturn, without drawing-down on assets – you can also be in a position to put money back into the market, somewhere near the bottom.
Amid the gloom of 2007–2009, that opportunity – clear only in hindsight – came about for many investors. We could be close to another such opportunity.