by Asset Allocation Committee

In recent reports, we have discussed the yield curve and its value in signaling the business cycle.  One of the problems for investors with using the various permutations of the yield curve as a signaling device is that it gives such early warnings that it may not be all that useful.

This chart shows the total return for the S&P 500; the vertical lines denote the inversions of the yield curve.  The red lines represent when the inversion preceded a recession.  The black lines are inversions that resulted in false positives.[1]  The data shows that exiting equities at the point of inversion would, in several cases, be premature.  It might make sense to reduce equity exposure, but a complete retreat would not be warranted.

Labor market signals of recession tend to occur at or just before a downturn, but they also give us insight into when a recession may be imminent.  There are two indicators we like.  The first is the rolling 12-month sum of the monthly change in non-farm payrolls.  A reading of 1.5 million jobs is the indicator; falling below that level means a recession is near or underway.

The current reading is 2.074 mm, meaning payrolls remain in expansion mode.  The second indicator is the two-year change in the unemployment rate.

The current unemployment rate is 3.7%; in August 2017, it was 4.4%, meaning we still haven’t triggered a recession signal.  If the unemployment rate remains stable, we could be close to a recession signal in September 2020.

The labor market data suggests a recession isn’t imminent, meaning investors should avoid becoming overly defensive at this juncture.  That doesn’t mean one should not be watchful, but overreacting to the yield curve would be imprudent for most investors.

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[1] We are treating the current inversion as a false positive until proven otherwise.

by Asset Allocation Committee

In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions.  The indicator is constructed using commodity prices, initial claims and consumer confidence.  The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.  In this report, we will update the indicator with August data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the economy did slip late last year but has stabilized in 2019.  We have placed vertical lines at certain points when the indicator fell below zero.  It works fairly well as a signal that equities are turning lower, but there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or already underway and the equity markets have already begun their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at minus 1.0.  This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates.  At the same time, the fact that this variation of the indicator is just below zero raises caution.

What does the indicator say now?  The economy has decelerated but is not yet at a point where investors should become defensive.  Breaking below the red line would be our signal to expect a broader downturn.  As we have noted over the past two weeks, other indicators have signaled rising odds of recession.  We continue to monitor conditions closely but, as noted above, it is still too early to shift portfolios into a fully defensive stance.

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by Asset Allocation Committee

As various permutations of the yield curve invert, projections of recession are increasing.  One of our favorites, the 10-year T-note/fed funds yield curve, has been inverted for three months.

This chart shows the history of this yield curve; since 1960, every recession was preceded by an inversion of this indicator.  However, that isn’t to say that every inversion led to a recession. There were two false positives in the series, one in 1965 and another in 1998.  The former we consider a true false positive as the inversion lasted several months but a recession didn’t follow.  The latter event only lasted one month and was tied to the financial turmoil of the Asian Economic Crisis, the collapse of Long-Term Capital Management and the Russian debt default.  The fact that the inversion was short-lived weakens the case that it was a true inversion.

If this signal of recession holds, when does it arrive?  Here is a look at the timing:

On average, recessions occur 15 months after inversion; that would put the onset around next September.  The range is eight months to 18 months.  Using that range, the recession could begin as early as February 2020 or as late as February 2021.  Although this history offers some insight into timing, the reality is that the number of events is rather limited.  Thus, investors should treat the data as a guide.  The economic data remains mixed, but the preponderance of the evidence suggests that the U.S. economy is weakening but not in recession.

As we have noted before, recessions tend to have two causal factors, policy error and geopolitical events.  The 1973-75 and 1990-91 recessions are considered to be partly due to geopolitical factors; the former was affected by the Arab Oil Embargo and the latter by the Persian Gulf War.  However, both also had yield curve inversions.  It is quite possible that the geopolitical events caused the recessions to occur faster than they might have otherwise in the absence of these events.

We are watching the trade conflict with great interest because it might affect the timing of a downturn.  If the trade conflict worsens, lifting import prices and forcing the Fed to slow its path of lowering rates, the recession might occur sooner than it otherwise would.  A recession would certainly affect the 2020 elections; no incumbent has survived a recession since Calvin Coolidge.  We will likely begin to prepare for a downturn next year.  If the trade conflict worsens, the timing may be accelerated.

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by Asset Allocation Committee

Recession worries have increased due to falling long-duration interest rates and the short-lived inversion of the two-year/10-year T-note spread.  Although this spread is important, it is merely one in a whole series of permutations of the yield curve.  Our preferred measure is the 10-year/fed funds spread because it measures the long end of the yield curve to the policy rate and thus should provide a clearer picture of whether or not the central bank policy is too tight.  It is also the same spread the Conference Board uses in its leading economic indicators.

This chart shows the aforementioned spread.  Since the 1970 recession, the spread has inverted before every recession.  It did have two false positives, one in 1966 and another in 1998.  The recent inversion could be a false positive as well, but it makes sense that investors should be concerned about a recession.  This is because equities often decline during recessions; in some cases, the drop is significant.

This chart shows the weekly Friday close for the S&P 500 on a log scale.  We have regressed a time trend through the data.  In nearly all recessions, some weakness in equities is observed, although often the decline in stocks predates the recession to some degree.

This chart shows the performance of the S&P 500 around inversions.  We took every inversion from 1966 forward, indexing the S&P to 100 at the month of inversion.

We added symbols to the 1966 and 1998 inversions as both were false positives for recession.  In the former case, equities fell in the first 10 months of inversion but rallied.  In 1998, there was a brief drop followed by a strong rally in stocks.  Generally speaking, false positives are buying opportunities.  All the other events were eventually followed by recessions.  However, as the data shows, the dispersion is remarkably wide.  It’s hard to ascertain a clear message with this much noise, but, in general, a case can be made that a delayed recession after inversion tends to support equity values.  The other message is that valuations and inflation issues do matter around inversions.  The worst performing markets in the two years after an inversion was 1973, a bear market that suffered from falling margins and multiples, and 2000, which was a highly overvalued equity market.  Other than these lessons, the data tends to support the idea that panic around an inversion is probably unwise, which is what the average of all the events tends to suggest.  Each inversion has specific characteristics that affect equity market performance.  In the current environment, we would be most concerned about profit margins; if a recession occurs, we would expect margins to contract which would likely trigger a notable bear market.  So far, margins have declined but remain historically elevated.  Margins will likely be the key to equity performance in the coming quarters.

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