by Erik Ristuben, Russell Investments
On July 1, America entered unknown economic territory. The U.S. is now in the 11th year of continuous economic expansion without a recession to blemish the record.1 This is the longest the nation has ever gone without falling into an economic downturn. Paired with the country’s equally-impressive equity bull market—which officially became the longest in U.S. history in March2—2019 has become a year defined by record highs.
But the good times won’t last forever. Slumping global growth, heightened trade tensions and diminishing levels of business confidence and manufacturing suggest that the economic expansion is running out of steam. But when exactly might it breathe its last?
Divergent views in equity and bond markets
Not surprisingly, markets have been obsessing over this question for the better part of the year. In fact, ever since the equity market sell-off in the fourth quarter of 2018, this appears to have been the central question driving market performance. For the first four months of this year, investors were clearly betting that with the U.S. Federal Reserve (the Fed) on the sidelines and unlikely to raise interest rates—which could have posed a serious threat to future economic activity—the economy would not slip into recession in the near-term. This allowed markets to rally significantly from their early-January lows, with the S&P 500® Index posting a year-to-date return of 18.25% by the end of April.
Meanwhile, the bond market was not basking in the same sense of optimism. While stocks were rallying, so too were bond prices, as interest rates fell significantly by springtime. By the end of April, the yield on the benchmark 10-year U.S. Treasury note had sunk 28 basis points from its mid-January high, down to 2.51% from 2.79%. While rates were falling, the yield curve was also flattening, meaning long-term and short-term interest rates were coming closer and closer to each other. As a rule, significant drops in interest rates generally mean the bond market is concerned that economic growth is about to slow. The flattening of the yield curve that occurs as longer term rates drop while short term rates remain the same is called a bear flattener. The worries in the first few months of the year were very likely based on the fear that the Fed might have already gone too far in raising rates—to the point where monetary policy could be considered restrictive. Indeed, many economists feel that the catalyst for most U.S. recessions is a Fed that raises interest rates too high, thereby slowing economic activity to the point where it starts to contract.
By the time the calendar flipped to May, the bond market and the equity market appeared to have very different views on where the economy was headed. Then, trade tensions bubbled to the surface yet again. On May 13, the U.S. raised tariffs on $200 billion worth of Chinese imports from 10% to 25%, and threatened to apply the 25% rate to the remainder of all Chinese goods it imports. Under such a scenario, over $500 billion worth of Chinese goods would have been subject to a 25% tariff.
The sudden escalation touched off a significant market response, with the S&P 500 selling off 6% in May. Even more significant was the bond market reaction. The 10-year yield collapsed in the month from 2.51% to 2.13% ,while the U.S. Treasury yield curve (measured by the difference in yields between 10-year and 3-month notes)—which had temporarily inverted in late March—re-inverted on May 23 and has remained inverted ever since. Then, just last week, the 10-year yield hit a three-year low of 1.475%, briefly inverting the spread between 10-year and 2-year notes.3
What's driving the surge in bond market pricing? In short, pricing has become extreme because investors are expecting—with near certainty—multiple Fed rate cuts by year’s end. In the past, when the bond market has been in this position, two things of note have happened:
- The Fed has never failed to deliver interest rate cuts. 2019 has already proven no different, with the central bank slashing borrowing costs by 25 basis points at the conclusion of last month’s meeting. We expect an additional rate cut in September and again potentially in October.
- The U.S. economy has only escaped recession in the ensuing 12 months on one occasion. That was in 1998, when the impacts of the Asian debt crisis, Russian debt crisis and the failure of Long Term Capital Management forced the Fed to lower rates. In this instance, the next recession did not start until almost three years later.
The June rally: False hope for markets?
In June, the equity market rallied hard on the expectation that the Fed would come to the rescue by cutting interest rates. Evidently, it seems that the stock market believes a 1998 scenario is in play. This could very well be the case. Aside from the threat that trade uncertainty presents, our central view is that a recession is more than 12 months away. Currently, our BCI economic model is estimating a one-in-three chance of a recession in the next 12 months.
Yet the ongoing uncertainty around trade remains a significant wildcard issue, as seen by the sharp market selloff earlier this month. Trade tensions have caused a dramatic drop in CEO confidence, as measured by The Conference Board. The organization’s CEO confidence index plunged from a reading of 57 to 42 during the fourth quarter of last year, and has been stuck at 43 for the last two quarters (50 is the cut-off line between optimism and pessimism among CEOs).4 The reading of 43 ranks in the bottom fifth of all results on a historical basis. This lack of confidence has already resulted in a significant stagnation of spending on capital goods, which in turn has led to a serious downshifting in manufacturing on a global level. In June, the J.P.Morgan Global Manufacturing PMI™ fell to a contractionary level of 49.4, with the U.S. nearing a 10-year low at 50.6.5
Our view is that this marks a serious inflection point for the U.S. and the global economy. Will Fed rate cuts be enough to offset CEO confidence? Enough to un-invert the yield curve? Will ongoing trade tensions and the lack of CEO confidence begin to affect hiring?
The bottom line
Burning questions like these are what keep us awake at night. Amid this heightened stage of uncertainty, we can’t stress enough the importance of staying disciplined, taking a multi-asset approach and sticking to your original investment plan. Remember that this plan likely was created with the knowledge—if not the expectation—that an economic recession and/or a bear market would occur at some point. As such, the plan was designed specifically for you to successfully navigate through troubled times.
In addition, we believe now is the time to seriously consider diversifying your portfolio beyond the U.S. We like the value offered by Japanese equities, the Japanese yen and emerging-market currencies. Remember, when uncertainty reigns, diversification rules. As we sail further into uncharted waters, this is sure to become a mantra worth living by.
1 Source: https://www.cnbc.com/2019/07/02/this-is-now-the-longest-us-economic-expansion-in-history.html
2 Source: https://www.wsj.com/articles/what-yogi-berra-would-have-said-about-this-bull-market-11560524404
3 Source: https://www.cnbc.com/2019/08/15/us-bonds-30-year-treasury-yield-falls-below-2percent-for-first-time-ever.htm
4 Source: https://www.conference-board.org/data/ceoconfidence.cfm
5 Source: https://www.markiteconomics.com/Public/Home/PressRelease/f83452ee0ff14466acab4184f5c3b705
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