Of late, there has been a lot of talk about a coming recession. Is the sky indeed falling over the world's most significant economies? Is this the end of the longest economic expansion in US history? Well, predicting future events is still very difficult despite today’s tremendous advances in computing power.
Like mathematician David Orrell would say, predictions may be right for a couple of days, but future extreme events are impossible to foretell. This especially so, if the projections are about the economy.
Economists say that there is no one perfect model of an economy. If therefore an attempt at prediction is made, large deviations could occur. Nevertheless, while markets cannot be foretold, risks can be calculated. The tools economists have at hand can prepare investors for an unfavourable economic outcome.
Confusing Economic Signals
The current political and economic distress has had a very adverse effect on the global economy. Still, not all has been doom and gloom. As an illustration, a report from the National Federation of Independent Business (NFIB) says that Main Street is thriving.
Small businesses are growing, investing, and hiring at historically high levels. The NFIB has not sounded an alarm over an oncoming recession. William Dunkelberg, the NFIB chief nonetheless warns that the pessimistic but contagious talk of a cooling economy might eventually create a false reality, halting this growth.
The first half of 2019, marked the most extended cycle of US economic growth, which began on June 2009. According to the National Bureau of Economic Research, it is the longest run ever recorded since 1854. Nevertheless, the cumulative quarterly GDP growth figures have lessened than those of previous booms.
The unemployment rate has also dipped from a high of 10 percent in late 2009 to 3.6 percent in May 2019. This is the lowest this rate has been since 1969. Despite political and economical pumps, the expansion has trucked along, fueled by the 2018 Trump tax cut and a better business regulatory environment.
Bond Yields and The Economy
Wall Street has been particularly unnerved about the halting of the ongoing expansion and with good reason. As an illustration, 77 percent of businesses issuing pre-announcements in July 2019, said that they expected far fewer profits than Wall Street had predicted. A vibrant stock market is a good indicator of a flourishing economy.
As businesses bring in more profits, their stocks receive a higher valuation.
Unfortunately, this rise in profits increases inflation. Inflation adversely affects the bond markets, causing their prices to fall as investors move their money to the more profitable stock market. In the case of the US, this event rattled the Federal Reserve. The Fed, therefore, began to raise interest rates, which in turn made borrowing more expensive for businesses.
When the Fed began to lower their interest rates in 2019, bond prices began to rise. This scenario economists say, is a signal of an oncoming recession. The rule of thumb is stock, and bond prices tend to move in the same direction. Whenever their movements are the opposite of each other, it is a pointer of an oncoming change.
Stock markets can plunge for several reasons, but they do always signal a cool down in economic growth. This scenario is what drives investors to bonds, which in turn raises their prices. This environment, unfortunately, causes bond yields to fall.
Bonds are safe haven assets that offer periodic interest payoffs and the safety of principal. Treasury bonds are indeed regarded as risk-free investments with yields associated with the interest rates set by the Fed. Government bond yields will, therefore, fall as the Fed cuts its rates. While this event, of course, has made investors nervous, perhaps the most unsettling occurrence has been a sighting of a yield curve inversion.
Like a bad penny, the inverted yield curve is viewed as a more prominent sign of oncoming economic turmoil. An inversion of the 2 year, 10-year Treasury bond curve implies that the yield of the long-term bonds is lower than that of 2-year bonds. Data shows that in seven instances when this event has occurred, a biting recession took place less than two years afterward. There, of course, are analysts that say this time, the inverted yield curve is a red herring event since the retail market is thriving.
Recession Code Red?
Nonetheless, Campbell Harvey, the godfather of the inverted yield curve has issued a recession code red. The University of Duke finance professor and the brain behind the inverted yield curve and its economic downturn correlation says that the economy is going to slow down.
The ten year and 3-month bond yields have, for instance, sustained their inversion for one full quarter. There was one bright spot in mid-2019 when the returns of these two bonds lingered at the same level.
One of Harvey's most studied curves, the 5 year and 3-month yields curves have been inverted since February 2019. Perhaps the most notable fact is that the spread between the ten year and 2-year notes flashed red in August. The academician also notes that besides the inverted yield curves, other indications of a cooling economy include GDP, stock market performance, and unemployment rates.
The data that these indicators have shown over the past quarter shows an increasingly stifled economy as the US-China trade war fallout begins to bite. The inverted yield curve is a sure sign that investors are willing to take less interest in their long-term bonds.
However, one rule of capitalism is that investors earn more when they lend money for more extended periods. Therefore, interest earned from longer-term lending is higher than that of short-term bonds. Unfortunately, the scramble for long-term bonds has stoked their demand lowering their yields and causing the inverted yield curve.
Is It Safe to Conclude That A Recession Is Imminent?
While Campbell Harvey and a horde of other pundits have claimed that a recession is coming, some critics beg to differ. They claim that current data is insufficient to be a reliable indicator of such a significant economic event. They claim that the current quantitative easing measures done by the Fed have interfered with the yield curve's balance. As the debate rages, it does pay to be cautiously optimistic, in the face of the ongoing global economic and political events.
Central banks around the world, for instance, have undertaken measures that show that they are trying to stave off an economic downturn. The Fed, for instance, after consecutive rate hikes in 2017 and 2018 have slashed their rates in 2019. The European Central Bank (ECB) has recently made a ten basis point cut, lowering its interest rate to -0.5 percent. At least 30 central banks globally, including those of India, Thailand, and New Zealand, have rolled out their quantitative easing measures.
These efforts are a sure pointer that the global economy is in the doldrums. The inflation causing quantitative easing measures might, nonetheless, inject liquidity to the economy and spur growth. There are financial experts though that says central banks will need to do more than cut rates to steer the economy back to growth. There are, consequently growing fears that these institutions might begin to debase their currencies.
So, What Should A Prudent Investor Do?
Fortunately, with some research and certainty of their level of risk averseness, an investor can take some precautions against a hard-hitting recession. Such introspection, however, does not come easy, but with the assistance of an investment advisor, meaningful investing advice can be obtained.
As an illustration, while it is true that a recession could be on the way, the effect of a downturn can be favorable to certain investors. Younger investors, for instance, should be less worried as investors turn to safe-haven investments such as bonds. Millennials and Gen Z have a few decades to go before they are off to retirement. If therefore, there is a recession in 2020, their long-term investments still have time to bounce back.
Another advantage working for young investors is that they do not have massive amounts of capital invested in the market yet. This softens the recession blow for this generation. A stock market that does nothing but dip can be a fantastic opportunity for such an investor.
Away from the riskier markets, safe-haven assets such as Bitcoin, gold, and silver have been performing incredibly well in 2019. Silver and gold have, for example, been on a bull run making a 20 percent surge year to date rise in value. Bitcoin has in 2019 made a speedy recovery in value rising above the $10,000 mark. The digital currency now has a slew of investors gunning for it, including Wall Street movers and shakers, hedge funds and fervent retail investors.
These asset's store of value qualities makes them the safest investments to turn to in an unstable and uncertain economic future. With the demand for gold rising by the day, as central banks and investors stock up, the precious yellow metal's value has gone above the $1,500 mark. While this cost might be too high for some investors, there are other assets such as Silver and Bitcoin, whose price is still undervalued.