This month, the yield on US 10-year government debt fell below the yield on 2-year government debt for the first time since the financial crises. Since an inversion of the yield curve has preceded every US postwar recession, web searches for the term "recession" have recently spiked. Importantly for investors, an inverted yield curve has not historically proven to be a reliable "sell signal" for stocks. But the inverted US curve does serve as a good reflection of two fears we see currently pervading sentiment. First, fear that that the recent slowdown in economic data, mostly notable in the global manufacturing sector, will broaden and deepen. Second, fear that President Trump is willing to push the US economy into a recession to fulfill his trade objectives.
Will a manufacturing recession manufacture a recession?
Recent data points to a sharp slowdown in the manufacturing sector. Manufacturing is a relatively small, and naturally cyclical, part of the global economy. Overall, we do not think that a manufacturing slowdown will be enough to trigger a wider global recession. But a key question is whether this weakness will broaden into consumption, triggering a full US or global recession.
Tariffs: Truce or dare?
Clearly, a major driver of how both consumer confidence and global manufacturing will evolve from here depends on the trade dispute between the US and China. There is little evidence that President Trump values predictability as part of his tariff policy, so he may alter his behavior at any time. But we have observed certain patterns around previous trade developments:
- Observation 1: Previously announced tariffs have always eventually been implemented
Therefore we believe it is likely that the 10% tariffs will ultimately be imposed on the USD 300bn of Chinese imports not currently subject to tariffs.
- Observation 2: Tariffs have only been fully implemented with the S&P 500 trading at a higher level than when pledged
While we don’t think the President bases his trade policy on the US stock market alone, these facts do display a certain sensitivity to the impact of tariffs on the US economy, business sentiment, and financial conditions. This pattern suggests that a further delay is possible.
We still think it is too early to call an end to the expansion, but the risks of a recession have increased. While we wait for greater clarity, we have opted to reduce risk this month, moving back to a neutral stance on equities by closing our overweights to emerging market and Japanese stocks.
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