Recession Worries Sink Stocks

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By Charles Tan - August 14, 2019

Less than a month removed from hitting all-time highs, stocks tumbled as the bond market flashed worrisome signals about the state of the global economy. Because global growth has slowed in recent quarters, and because of the trade tension between the U.S. and the rest of the world, the stock market has been volatile and prone to sharp moves as each day’s news brings relief or new worries.

Yield Curve Inversion May Be an Ominous Sign

An inverted yield curve is the bond market’s way of saying that all is not well in the economy. Because we are in the longest economic expansion in history and by some measures one of the longest bull markets in history, stock investors are nervous the party might be over. We just received data showing a slowdown in German manufacturing activity, Chinese industrial production and the broader economy. This suggests to some investors that the trade war may put the nail in the global economic coffin. As a result, investors flooded into bonds, driving down yields, and causing the inversion.

What’s an Inverted Yield Curve and Why Does the Stock Market Care?

The curve shows bond yields over time, from cash rates all the way out to 10-, 20-, and even 30-year bonds. Typically, the economy is growing, and the yield curve points up with long-term bonds returning more than cash and short-term bonds. But heading into recessions, the yield curve points down, or “inverts” with long-term bonds yielding less than cash and short-term securities. Interest rates matter for stocks for many reasons, including effects on profitability and valuation. However, the reason they caused this most recent stock market sell-off is what rates tell us about the health of the economy.

What is Bond Market Saying?

Recall that while longer-term bond yields are controlled by the market, the shortest-term cash rates are controlled by the Federal Reserve (Fed). So, the market is telling us the Fed is wrong and that short-term rates are too high. Indeed, U.S. long rates are lower than cash rates, and all around the developed world, many bond yields are negative. That means that investors are willing to pay for the privilege of the safety of holding a government-backed bond.

The Timing Isn’t Clear

Keep in mind that while every recession has been preceded by an inverted yield curve, not every inverted yield curve accurately predicts recession. This means inversion is not a fool-proof predictor. Even if the bond market is correct and a recession is coming, the question remains, when? On June 6, 2019 (41 days ago), the yield on the 10-year Treasury bond fell below the 3-month yield.  Over the past 50 years, the shortest period between an inversion on this part of the curve and be beginning of a recession was 140 days, which occurred in 1973. The longest stretch between inversion and recession was 486 days beginning in 2006.1

What Should We be Watching in the Meantime?

Despite the bond market’s signals, we believe the U.S. economy may remain the world’s strongest and most resilient. The trade war remains one of the biggest threats. But, because the impact of Fed activity tends to lag, we’re also watching for signs that the Fed may have gone too far in its tightening regime before last month’s rate cut. Meanwhile, China’s economy, which was already slowing, is suffering from under the weight of the trade war. Europe and Japan are weak as well.

Time to Play Defense

Over the course of an economic cycle we believe there are times when it makes sense for some investors to be aggressive and others when investors should be more cautious. We think this is a time when a defensive posture is the most prudent. We’re not suggesting making big changes due to recent market movements. Rather, as my colleague Rich Weiss suggested in a recent post, you should evaluate your portfolio based on where you are in your life and how close you are to your financial goal. The closer you are to your goal, the more we believe it makes sense to reduce risk.

1Source: Bianco Research

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