A two-tier global economy is more of a threat to markets than an inverted yield curve
Defying the laws of gravity
The bond market’s warning of an impending US recession grew stronger in August as the yield curve “inverted” between the 2-year and 10-year US Treasury bonds for the first time since 2007, and follows on from the 3-month Treasury bills yield rising above the 10-year yield in May. With the yield curve inverting prior to every US recession since 1955, it is generally seen as one of the most reliable leading indicators of recessions.
The equity market, on the other hand, is expecting a healthy US economy – the consensus of equity analysts is for earnings growth of 8% over the next 12 months, while backing out the implied earnings growth from the equity market has earnings growth at circa 7%. For this to be achieved it would require the US economy to grow robustly over the next year. If the bond market is right, then this could be the equity market’s Wile E Coyote moment (from the Road Runner cartoon), meaning it has run off the cliff and is briefly defying the laws of gravity before it falls into the canyon below. Given valuations for US equity are stretched, recession-induced falls would be particularly large.
The inverted yield curve
So let’s explore why the inverted yield curve has been such an exemplary forecaster of US recessions. Two theories dominate: it captures the tightness of monetary policy and/or it captures the animal spirits (or confidence). When cash rates are higher than longer-term bond yields it suggests monetary policy is tight, as the cash rate is above the market’s view of the long run interest rate. The animal spirits view is based on the low bond yield reflecting the market’s poor view of the outlook.
Luckily for us there is another area of the US economy we can analyse to capture the impact of monetary policy and animal spirits: the US housing market. Housing activity is highly sensitive to monetary policy, given the heavy reliance on debt; and given the size of the commitment to build a house, it is also a good proxy for the animal spirits.
Currently the housing market has a different view to the yield curve, with a survey of homebuilders suggesting improving conditions this year, and the rises in their stock prices also reflecting the better operating environment.
The last time we saw this divergence between the yield curve and the housing market was the later part of the 90s, when the yield curve inverted in 1998 while the conditions of homebuilders continued to improve.
This is not the only parallel; there are several others.
First, both involved a shock to trade and manufacturing. The 90s was driven by the Asian crisis, and now through the trade war.
Secondly, there was the divergence between bonds and equities. Bond yields fell throughout 1998, and equities rose over the first half of the year before hitting a roadblock, as the Russia crisis and the collapse of hedge fund LTCM dominated the second half of the year.
Third, the global economy outside of manufacturing had a much better relative performance, seeing a two-tier global economy, with the US consumer booming in 1998. This is also the case today, with business surveys showing that while 70% of surveyed countries have an underperforming manufacturing sector, none have a problem with their service sectors, and the US consumer is supporting the global economy.
A defensive position
Just as the recession was averted in the late 1990s, we expect this to be the case in the near term. However, we expect the two-tiered economy to hit company profits. Given this view is not priced in by equity markets, we believe it is vulnerable, and believe a defensive position is still warranted. However, any weakness would be a buying opportunity.
In August we added to this defensive position: the strategy purchased 30-year US Treasury bonds, adding 0.5 years of duration and taking the duration of the strategy to 2 years. We also purchased put options on the S&P500, equivalent to a 2.5% position, which would profit if the market fell.
There are two risks around our view. First, the US economy heads into recession next year, which would mean we are not defensive enough. This could be because we are underestimating the impact of the current round of tariffs on the US consumer, which focus more on consumer goods. We are closely watching for signs that the US consumers’ mood is deteriorating and will adjust positioning if we spot a change.
The second risk is that the equity market is not impacted by the two-tier economy and the bear market in the second half of 1998 was related to the crises and not the economic situation. Without a crisis the equity market could focus on the broader economy and look through the manufacturing weakness. Given our modelling suggests soft earnings, it is hard to see a melt up in the equity market, so we believe the opportunity cost of being defensive is low if this scenario come to fruition.
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