In focus - Managers' views

Is the US heading for recession in 2020?

We look at what bond and labour markets are signalling about the prospects for the US economy next year.

28/11/2019

Martin Arnold

Martin Arnold

Economist

The ongoing trade tensions and some recent weak data from the manufacturing sector have raised questions over a slowdown in the US economy. Taking a look at the bond and labour markets may tell us whether or not the US could go into recession in 2020.

Government and corporate bonds show mixed signals

The bond market has a good track record of predicting recession for the US economy. With one exception, in 1966, every time the US yield curve has inverted, the US has entered recession within 18 months. An inverted yield curve is defined by the US 10-year bond yield being lower than the three-month Treasury bill rate at month-end. The most recent of such yield curve inversion was in May this year, suggesting that the US economy may be destined for an imminent recession.

However, the corporate bond market tells a different story. The New York Federal Reserve has several models to forecast a US recession, one of which places the probability of recession at a far lower level. This is the excess bond premium (EBP) model, which is designed to gauge investor sentiment in the corporate bond market. The current probability of recession according to this indicator is 10%.

Labour market robust, for now

The jobs market remains an area of strength in the US. US consumer balance sheets remain in a solid shape. Workers in the US have begun to work fewer hours but earnings growth remains healthy, and consequently real aggregate income growth remains relatively robust. Real aggregate weekly incomes have a strong correlation with consumption expenditures in the US. US consumer balance sheets remain healthy and should be supportive of further growth in economic activity going into 2020.

However, momentum in the jobs market appears to be losing steam, as the rate of jobs growth slows. If this continues, a period of economic slowdown (or outright recession) is likely to come sooner rather than later. Forward-looking indicators in the jobs market also highlight the need for caution. The US Conference Board’s Employment Trends Indicator (ETI) has stabilised, potentially reaching a turning point. This could mean a recession will follow or it could mean that, as in 2014/15, the economic expansion will continue.

How can investors respond?

Although there are some signs that growth is slowing, a recession is not necessarily on the way. There is support from central banks with interest rates near zero for most major economies. Even so, investors may want to consider how sensitive their stock market investments are to the economic cycle. Periods of slowdown and recession are the phases of the business cycle when shares perform most poorly.

We are forecasting a profits recession for US companies, with profit margins being squeezed by wage growth and slowing demand. If the economic slowdown gathers pace, companies are likely to reduce capital spending and headcount. In this scenario, investors may want to exercise caution when it comes to lofty stock market valuations.

US economic profits – actual and forecast

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Bond market prices are also at relatively expensive levels. These could soon start to unwind, even though bonds tend to perform better than equities during a recession. The yield curve tends to turn from inversion toward a more normal upward sloping shape quite quickly (meaning long-dated yields rising and/or shorter dated yields falling).

Historically, the average length of US curve inversions averages around nine months, suggesting that the yield curve could be positively sloped by around end-Q1 2020.

Combining the outlook from the labour and bond markets, it appears that a continued slowdown in the US economy is inevitable, but that does not necessarily need to lead to a recession, especially if policy support provides a foundation for activity. Certainly, policy support, whether from the central bank or government, could help maintain valuations at high levels.

 

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