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14 Aug 2019

Bond yields signal recession risk, we say not so fast

Weak economic data and a further flattening of the US Treasury yield curve on Wednesday led the S&P 500 to decline 2.93%, global equities 2.85%, and emerging market stocks 2.88%.

Mounting economic worries stemmed from weaker-than-expected Chinese retail sales and industrial production, while German GDP contracted in the second quarter. This continues a multi-month trend of weakening global growth, concentrated primarily in manufacturing. The 10-year US Treasury yield fell below the 2-year yield for the first time in over a decade—a negative sign because a yield curve inversion occurred prior to each of the past seven  recessions. In addition, the 30-year Treasury yield fell to a record low in a flight to safety, suggesting investors expect low rates to persist for an extended period. The price of gold, up 0.7% Wednesday and 18% for the year, is another sign of investor fear. But despite such indications of concern from the market, we still see just a 25% chance of a US recession in 2020.

The US economy remains well placed to withstand continued weakness in global manufacturing, so long as there isn’t a further escalation in the US-China trade dispute whereby tariffs rise to 25% on all Chinese imports. GDP expanded at an annualized pace of 2.1% in the second quarter, with strong consumer spending compensating for declining business investment. The Federal Reserve has cut rates preemptively and we expect further easing— three cuts from September to March—to help support the economy, partly offsetting damage from the trade conflict.

Tuesday's decision by President Donald Trump to delay imposing a 10% tariff on the full USD 300bn of goods from China was a positive, though maybe less supportive than the markets originally perceived: While the US delayed some tariffs, it advanced toward imposing tariffs on a narrower range of goods, around USD 110bn according to Bloomberg, effective 1 September.

The good news was that delaying until 15 December the imposition of the tariff on the remaining goods suggests that US officials are eager to avoid a hit to economic growth. We had estimated that a 10% tariff applied to all goods would shave around a quarter of a percentage point off the US GDP growth in 2020. The ultimate impact will be less if the tariffs aren't applied in December, and far less than the 1-percentage-point hit to growth we estimate would occur if the tariff rate was 25% across the board, raising the recession probability in 2020 to 50%. Still, our base case is that the full 10% tariff will be applied in December with a 30% chance of additional escalation.

Unlike trade conflicts, an inverted yield curve by itself has limited economic impact. Instead, its signal about the health of the economy is what matters, and it is not as negative as some investors fear. For one, there’s been a long and variable lag between initial inversion and the start of recessions: 22 months on average, ranging from 10 to 36 months for the last five recessions. In addition, Treasury yields are being weighed down by the almost USD 16 trillion in sovereign bonds globally with a negative yield, distorting their signal about US economic activity. Finally, the length of time the yield curve is inverted, and how much is inverted, matter. If Fed rate cuts successfully steepen the curve comfortably into positive territory, this brief curve inversion may be a premature recession signal.

Neither does a yield curve inversion indicate it is time to sell equities. Since 1975, after an inversion in the 2-year/10-year yield curve, the S&P 500 has continued to rally for nearly two years, and has risen by 40% on average until hitting a bull market peak.

We remain confident that the US will avoid a recession next year. But we expect growth to remain muted, and it’s likely that rates will remain lower for longer as central banks try to support growth. Overall, we think this is a good environment for carry strategies as equity markets wait for clarity on trade and growth. We recently increased the size of our overweight in a basket of high-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars). We are also overweight in long-duration Treasuries and recommend a variety of dividend strategies in Europe and the US.