How to navigate the buoys and the rocks of today’s markets.
There’s a moment that sends a chill down the spine of any sailor when a rock suddenly appears, off wrong side of the bow. It doesn’t really matter whether the chart was wrong or the skipper missed a buoy—it’s undeniably a sign of trouble.
That same cold jolt struck investors this month with the arrival of inverted yield curves, wilting inflation expectations and an array of other economic oddities that weren’t on their charts. But it would be wrong to panic now.
The economic data have long showed these were rough waters. A deceleration was natural as we passed the mark for the longest U.S. expansion on record.
All year long, signs that the next U.S. recession may arrive soon have multiplied. By one count, nine major economies are either already in recession or teetering on the brink, including Germany, the United Kingdom, Italy, South Korea and Brazil. Growth continues to slow in China as authorities reined in credit last year and trade tensions hit. Japan, which never drives global trends much anymore, is bracing for further headwinds from a sales tax hike.
This leaves the United States still growing at a reasonable clip, with strong consumer sentiment and low unemployment outweighing the effects of lagging industrial indicators and weak corporate earnings.
On their own, these should be manageable challenges. Few noticed amid the trade turmoil that the U.S. avoided a budget crisis with a deal to extend the debt limit for two years. There is room for fiscal support from the likes of Germany and South Korea. China still has powerful tools to support credit growth and manage its deceleration. Dovish monetary policy at the world’s largest central banks should help make the correction shorter and shallower than usual.
But the chart is only a chart and the rocks are still rocks.
Regardless of the mixed economic data, bond yields keep drifting lower. The inverted yield curve itself does not trigger a recession, but rather suggests a lot of investors are worried about global growth and skeptical that we will get more than a whiff of sustained price inflation anytime soon.
Unexpectedly, prices and returns have been muted by large new global pools of cheap labor, by amazing new technologies that seem to make everything cheaper and by aging societies that just don’t spend like they used to. Against this backdrop, the legacy of unprecedented quantitative easing lingers in a world of high asset prices, rising debt and low rates.
Most investors have not updated their models to account for these oddities, and they aren’t sure how they should. The $17 trillion of debt that trades at negative yields are high on everyone’s mind, but the phenomenon was never in anyone’s economics textbooks.
INFLATION EXPECTATIONS AND NEGATIVE YIELDING BONDS
SOURCE: BLOOMBERG AS OF August 16, 2019
Meanwhile, the standard late-cycle growth jitters have worsened as the U.S.-China trade war has lurched suddenly into a currency war and seems well on its way to a new global rivalry that will redefine geo-politics, technology supply chains and the world’s economy.
Clearly, the risks of recession have risen, and this confluence of so many weird and unpredictable currents helps explain the temptation to brace for disaster. Of course, it’s always possible that this fragile sentiment today shatters altogether on the news of an unexpected bank failure, an uncontained cyber-attack or a dramatic expansion of trade tensions with Europe or Japan.
There may come fresh moments to panic, but short of large systemic shocks, the longstanding fundamentals still apply.
U.S. 10-YEAR YIELD AND S&P 500 DIVIDEND YIELD
SOURCE: BLOOMBERG AS OF AUGUST 16, 2019
Economically, cheaper money should help extend the U.S. consumer cycle and may even prop up corporate capital expenditures. Politically, investors are learning to adjust to a world of trade turmoil, one where the uncertainty has yet to spread beyond bilateral flows between the U.S. and China. Meanwhile, stocks, which only recently touched record highs, now look relatively attractive on both dividend yields and valuation multiples.
This means that we may not actually notice the next recession when it hits, as it only appears in revisions to earlier and often confusing economic data. Markets may be volatile in the meantime as we make sense of economic forces and relationships that are different from those that shaped earlier cycles.
Still, just because a chart needs updating to account for some new shoals and currents, that doesn’t mean we should jump ship just yet.