Much has been made about the anxiety created by recent negative global macro factors. Be it a slowing China, trade war and Brexit stalemates, the 10-year German Bund rate crossing into negative territory or the Euro-zone economy forever sliding further into a state of “Japanification” (a perpetual state of low growth, inflation, and interest rates).
But it is the recent yield inversion of the three month and 10-year US treasury bond rates that has many foreheads glistening. This uncommon event is seen by many as the most reliable available leading indicator for an impending recession. Its importance somewhat perpetuated by the US Federal Reserve who also recognise this as a powerful predictor and regularly publish a measure of probable recession which leverages this as a critical indicator, now showing the chances of a recession have risen to 25%.
A yield inversion has occurred before every recession in the US, except for 1967 where a ‘credit crunch’ led to a marked decline in industrial production and falling 10-year yields, though there was no technical recession declared. Otherwise, the inverse yield pattern is consistent, and many are becoming increasingly worried, as the US’ significance on the future direction of the global economy is obvious. Readers may wish to look at the New York district of the US Federal Reserve website where under the Economic Research page, a section is dedicated to the usefulness of using the yield curve inversion as a predictor of U.S. recessions.*
While the above comments and undernoted graph shows previous yield inversion events and their correlation with past recessions need no explaining, we caution investors from reacting prematurely to this recent event. Here is why:
- Though a yield inversion has occurred before each recession since 1960, 50% of the actual eight recessions recorded occurred while the yields were not inverted. So, while there may have been good reasons at the time for yield inversion, there are many factors at play that lead to the end result which can take time. History shows it takes on average four to six quarters lead time from an inversion event before a recession ensues.
- Bond yield curves are flatter today than in the past, making it easier for the lines to cross. With expectations now that the Federal Reserve will not raise rates this year and in fact may look to cut rates into the future, as the lines were close it had taken little to tip it over the edge.
- Except for 1979 and 1982 when massive interest rate hikes were used to tame high inflation, most recessions in the US occurred because of turmoil in the financial system or asset markets. Examples such as savings and loans crisis, the tech bubble and the subprime mortgage loans crisis (GFC) were more reasons why recessions occurred. While that is not to say there is not an impending crisis around the corner, to date there is little to suggest a similar disaster is imminent.
- Generally, the yields need to stay inverted for some time before they can be considered as a reliable indicator. One-week periods should be ignored, and this recent inversion has only just occurred. However, should the yields remain inverted for over a month, and declining economic influencers eventuate, then the signal becomes more reliable.
- China is a more relevant economic influencer on Australia, though we would be indirectly impacted should the US economy fall into recession. If recent trade talks prove fruitful, and the US can arrest the rapid decline in the levels of exports to China, then that should lift domestic production, reignite their PMI, and subsequently help avoid what the inverted yield curves are suggesting.
While history is no guarantee of future events, it can be a useful guide and should be respected. For some time we have told our investors and members to be cognisant of the rising active risks present within the current global climate. While we caution against investing based on headlines and where possible to ‘block out the noise’, with prices having done so incredibly well and with so many of our great businesses trading on high multiples, we have encouraged our members to proactively take profits from stocks to create a cash pool from which future opportunities can be seized. The Lincoln Australian Funds have been engaging in such a practice, maintaining elevated cash positions and will likely continue to do so in the current climate.
While it is difficult to see a broad market rally from this point, there will be opportunities to accumulate, and it will continue to be a stock picker’s market. So rather than worrying about the things we cannot control like yield inversions, focus on the aspects we can, such as ensuring we are holding quality companies as a priority and prudently taking profits as stocks go up, building our war chest ready to see any future opportunities that volatility kindly provides us.
ELIO D’AMATO (@Elio_DAmato)
Elio D’Amato is the Executive Director at Lincoln indicators, a leading boutique fund manager and creator of Stock Doctor the complete share market research platform. www.lincolnindicators.com.au