The yield curve has been a constant topic of conversation among investors since mid-August, when the 2-year/10-year Treasury curve briefly inverted and launched furious speculation that a recession may be around the corner. The same holds true among Invesco’s market strategists, who have been debating what an inverted yield curve means and whether a recession is indeed inevitable.
Below, Brian Levitt, Invesco’s Global Market Strategist for North America, and Talley Léger, an Invesco Investment Strategist who specializes in the equity markets, compare their views on the state of the markets today.
Are markets fulfilling their own prophecy?
Brian: Did the yield curve inversion keep you up at night? Let’s be honest, it’s been a pretty good signal of recessions in the past. I’ve always told investors that recessions are the results of policy mistakes, and that I expect an inverted yield curve to be the first visible symptom of such a policy mistake. Trade uncertainty seems to be grinding business investment to a halt. Yet, every ounce of my being is telling me that this would all change with a shift in tone from the Trump administration.
Talley: Admittedly, the yield curve inversion did concern me. I seem to recall at similar points in past cycles that at least one pundit dismissed the efficacy of the yield curve as a business cycle indicator, which ultimately proved to be a slippery slope. As responsible stewards of capital, I think we’re right to at least consider the rising risk of recession.
In my view, the ebb and flow of cycles is only natural, whether it’s the changing of the seasons, sunrise and sunset, tidal forces, the rhythm of our bodies, or the waxing and waning of economic activity. From that perspective, the next business cycle contraction isn’t a matter of “if” but “when.” Encouragingly, as of late August, four of the five business cycle indicators I monitor were above their respective median readings at the onset of economic recessions since 1948. (By the way, the infamous yield curve is a component of two of those indicators.) In other words, it may be too soon to sound the recession alarm.
Are inverted yield curves symptoms of policy mistakes? Perhaps. A more philosophical question is: “Do inverted yield curves themselves actually cause recessions?” For the sake of argument (and this post), I’ll play devil’s advocate. Consider that the U.S. economy is largely finance-based. An inverted yield curve creates a disincentive for banks and other institutions to take risk and lend. Without a healthy flow of credit – the lifeblood of an economy – activity can slow or grind to a halt. To what degree are we fulfilling our own prophecy?
Brian: “Sunrise, sunset, swiftly go the days.” As a proud descendant of grandparents who fled the shtetls of Byelorussia, I welcome that reference – but I don’t agree with it. Recessions don’t have to happen. They are not like the rhythms of our bodies. Business contractions are the result of bad policy, plain and simple. You do, however, make a good point about fulfilling our own prophecies. I recently read that Google searches for “recession” are at their highest level since 2008.
My point is that the yield curve inverted because of policy mistakes – last year’s Federal Reserve tightening and the ongoing uncertainty around trade. In that sense, it is a symptom – not the cause – of recent economic deterioration. But you’re right; if it persists, it would not be positive for growth. I miss the days of 2% growth, 2% inflation and policy certainty. Where have you gone, 2017?
Barring a policy mistake, this decade-long cycle could continue to go on for far longer than most suspect. I still believe it will. It seems unlikely to me that the Trump administration will want to go into an election year with leading economic indicators deteriorating to this extent. I’m happy that your leading indicators are above median, but for how much longer? And is it too late to get defensive?
Talley: I agree that policy is set by human beings, and humans are prone to error. What are markets and economies? They’re organic, complex systems composed of fallible human beings. As such, the economy has a rhythm, just like us. To quote the philosopher George Santayana: “The earth has music for those who listen.” To clarify, I’m not arguing that contractions must happen. I’m simply making the empirical observation that they do. Alternatively, we could make the same argument based on physics and economic gravity. What goes up eventually comes back down.
Why are we debating the length of the current economic expansion? Because the business cycle shapes and guides the performance of stocks relative to bonds, and cyclical equity sectors relative to their defensive counterparts. In the near term, uncertainty and stock market volatility related to heightened trade tensions have asymmetrically punished global cyclicals, given related headwinds to worldwide exports/imports and economic growth. While defensive sectors have outperformed on a year-over-year basis, the bulk of the move seems to be behind us.
Expecting defensive sector outperformance to persist would be consistent with bonds continuing to outperform stocks and akin to making a recession call, which I’m unprepared to do at this stage. In the long term, I believe a potential trade deal would remove associated concerns about global growth, and that investors who stick to their plan would likely be rewarded for their patience.
Brian: Santayana also said, “Those who do not remember the past are condemned to repeat it.” Trade wars are as old as time. The theft of intellectual property was a staple of U.S. economic strategy in the years after the nation’s founding. The Entente and the Central Powers fought WWI, in part, for trade supremacy. They repeated this fight 20 years later. I much prefer the “trade wars” of the 21st century. While protectionism results in inefficient economic outcomes, such as higher prices for consumers, it doesn’t necessarily cause recessions. It’s the uncertainty of it all that’s worrisome.
Still, you may be right. It may be too late to get defensive. The 10-year Treasury rate is already below 1.5%. The utility sector is already up 20% this year. It feels like this could be a repeat of early 2016 where a redirection of policy – this time from the administration’s trade representatives rather than the Fed – could be the catalyst for the cyclical sectors to regain their leadership.
James Carville – the political advisor behind Bill Clinton’s presidential campaign rallying cry: “It’s the economy, stupid” – once said that he wanted to be reincarnated as the bond market, so he could intimidate everyone. Carville is still with us, but the yield curve is inverted and investors are feeling the pressure. Will the administration be intimidated?
Talley: We spend a lot of time worrying about foreign policy, but maybe we should give the U.S. economy, its consumers, and its businesses more credit for their resilience and dynamism. Together, they constitute almost 90% of gross domestic product (GDP), whereas the government represents less than 20% of the economy.1
To be clear, I’m not dismissing the inverse relationship between economic policy uncertainty, which is elevated, and business spending growth, which is depressed. Logically, a highly uncertain policy environment and increased costs in the form of tariffs are delaying businesses’ decisions to spend and invest. My point is that households are in good shape at a time when we’re seeing a rapid policy response from central banks around the world, including the Federal Reserve.
Technically, the current U.S. expansion began in June 2009, and is now the longest cycle on record, sustained by low interest rates, disinflation, and moderate real economic growth. True, trade wars and tariffs are downside risks to the economic outlook. However, global monetary policymakers are doing what they can to ensure the global expansion continues, albeit at a slower pace. In order for this cycle to meet an untimely demise, there would have to be a massive disruption in China or the U.S., neither of which appears likely to me given the current mix of accommodative policies from their respective central banks.
What about international markets? The U.S.-China trade war has been a significant headwind for Chinese and emerging market stocks. Given the Trump administration’s Twitter diplomacy, however, it’s reasonable to expect that trade risks could be toggled off with a tweet. If that happens, I believe that investors with no exposure to Chinese and emerging market stocks would miss a likely inflection point in those markets.
Brian: A nice contrarian view on emerging markets and China! I certainly see value in those markets. I’ll cede to you that final point.