The third quarter of 2019 kicked off on a positive note. On July 1, the S&P 500 surged to new highs and the Dow gained 117.47 points following President Donald Trump and Chinese President Xi Jinping’s trade agreement at the annual G20 Summit.1
While this favorable news temporarily put the market at ease, the fear of an upcoming economic downturn still lingers as a concern for many investors, especially because the Federal Reserve recently forecasted a 35 percent chance of a U.S. recession in the next 12 months.2
There are several conflicting data points regarding the strength of the U.S. economy. On one hand, the bond market is flashing warning signs that a recession is potentially near. The yield curve has been inverted for over three months, an occurrence that has been a precursor for the last seven U.S. recessions.3 Manufacturing data points are also starting to show signs of slight contraction after months of slowing growth.4
On the other hand, numerous market fundamentals continue to look healthy. The stock market has been behaving optimistically5 after the Fed took on a more dovish tone, combined with promising trade progress. Additionally, unemployment remains at a near-historic low6, consumer confidence has stayed relatively steady7 and defaults on lower quality corporate loans are not rising to worrisome levels.8
You don’t have to search long to find speculators forecasting a near-term recession. But there are a couple interesting notes about today’s environment that makes timing recession calls even more difficult than normal.
For one, this would be the lowest 10-year Treasury rate ever seen prior to a recession.9 In a typical cycle, you find that as a recovery continues, interest rates climb higher to a point that they begin to choke further economic growth. As borrowers can no longer afford the rates, they demand less borrowing, rates begin to fall and the economy begins to contract.
In this recovery, rates started low and ended even lower. Today we find ourselves in a situation with interest rates hovering at about 2 percent. Typically, interest rates within a range of 4 to 7 percent are what we tend to see before the economy falters.9
Furthermore, because of today’s low interest rates, it’s not evident where investors would put their money if we do in fact enter a recession. Investors often flee to bonds for safety in times of economic distress; however, investment grade bonds are currently yielding just 1.5 to 3 percent10 and do not present a viable alternative to stocks. Therefore, it is not at all clear that we would see a mass exodus from the stock market into bonds like we did in 200011 and 200812 when the markets declined 50 percent or more.
The bottom line is that recessions are hard enough to predict without considering the unique situation we find ourselves in today. Bond and stock markets are leading indicators but are not always accurate and are currently in disagreement.
Even if we do experience an economic downturn, it remains unclear how the market will react – the last two recessions occurred under vastly different circumstances and most market reactions to recessions are much less severe.
Sources:
1. CNBC.com – S&P 500 closes at new record as chipmakers get a boost from US-China trade truce
2. The Federal Reserve – Predicting future recessions
3. NPR – What just happened also occurred before the last 7 U.S. recessions. Reason to worry?
4. The Associated Press – US manufacturing growth slows in June for 3rd straight month
5. Yahoo! Finance – S&P 500
6. The White House – Unemployment still near historic low; Robust wage growth continues in May
7. FXStreet News – US consumer confidence: Still elevated, but below its 2018 high – Wells Fargo
8. J.P. Morgan – Market Insights
9. YCharts – 10 Year Treasury rate
10. CNBC.com – Bonds & rates
11. Investopedia – Dotcom Bubble
12. Investopedia – The 2007-08 Financial Crisis in review
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