By Jim Allworth
The Treasury yield curve has inverted—short-term interest rates have moved above long-term rates. Or, more precisely in this case, long-term rates have fallen below short-term rates.
This has garnered a lot of attention because in past economic cycles “inversion” has proven to be a reliable signal that a U.S. recession was on the way—on average about 11 to 14 months from the date of inversion.
Long, bruising equity bear markets, not just in the U.S. but also in Canada, the UK, Europe, and Japan, have been associated with U.S. recessions. These bear markets have typically started months before the recession gets underway. That makes inversion of the yield curve a valuable early warning signal that a more defensive investment state of mind is called for.
Is the recession clock starting?
The debate is already raging as to what, if any, credence should be given to the yield curve’s signal this time. There are a number of arguments—some very compelling—asserting that this inversion has occurred for very different reasons than in past cycles and therefore can be safely ignored. Perhaps. But in our experience, arguments like this have always surfaced around the time of previous inversions and, even though the mechanical reasoning was often correct, a recession (and equity bear market) eventually arrived.
Yield differential between the 10-year and 1-year U.S. Treasury notes
Yield curve inversions lead recessions by about a year on average.
There was one exception. The yield curve deeply inverted in 1965 and no recession ensued. However, U.S. GDP growth went from 10.1 percent (yes, that’s no typo, 10.1 percent!) in Q1 1966 to an effective standstill at 0.2 percent five quarters later. Around that time the stock market corrected by a brisk, but not disastrous, 20 percent.
Despite the wonderful track record of yield curve inversion as a recession/bear market early warning, we believe the routes taken by the economy and markets this time will undoubtedly wind up being different in some important aspects. That should make investors reluctant to bank everything on a signal given by just one indicator, no matter how historically reliable.
Eric Lascelles, chief economist for RBC Global Asset Management, rates 17 different economic variables and concludes that this longest of U.S. economic expansions is in its late-to-end-of-cycle phase. Of course, this last part of the expansion cycle before the next recession arrives could prove to be very drawn out. Certainly the early-cycle and mid-cycle phases were unusually extended.
Our U.S. recession scorecard follows six indicators, all of which have usefully warned of recessions ahead of time. Three (the yield curve, unemployment claims, and the Conference Board Leading Economic Index) have given their signals about a year ahead of the recession getting underway. The other three (see below) typically flash red much closer to the event. To date, only the yield curve has given a warning signal.
RBC Wealth Management U.S. economic indicator scorecard
|Yield curve (12-month to 10-year)||—||—|
|Conference Board Leading Index||—||—|
|ISM New Orders minus Inventories||—||—|
|Fed funds rate vs. nominal GDP growth||—||—|
Source - RBC Wealth Management, Bloomberg, FRED Economic Data St. Louis Fed
Indicators aside, we believe it will take some doing to get the U.S. into recession from here. One need only check in on the American consumer who thoroughly dominates the U.S. economy at almost 70 percent of GDP. Consumers are confident and for many good reasons. The unemployment rate was last below four percent in the mid-1960s; unemployment claims recently hit all-time lows; there are 7.6 million unfilled jobs on offer, according to the Labor Department; wage rates are rising nicely; home values and other components of household wealth are elevated and don’t look frothy or otherwise overly vulnerable; and consumer spending has remained mostly in line with income growth, suggesting household debt has not become unmanageable.
It has usually taken the arrival of tight monetary conditions to tip the economy into recession. “Tight money” has two necessary components: prohibitively high interest rates and banks that have become noticeably more restrictive in their lending practices. Neither is present today and with the Fed apparently on hold for the rest of this year, restrictive credit conditions still lie some ways off. Looking at the latest monthly survey of thousands of small and medium-sized U.S. businesses by the National Federation of Independent Business, just three percent of respondents (historically very low) report being unable to get the credit they need, while 51 percent say they need no credit.
And what does this say for investment strategy?
The “inversion signal” has always been hard for investors to get behind precisely because it has given such a long early warning. It is usually followed by several quarters of positive economic growth—one such interval lasted almost two years. And the stock market typically has some months or even quarters to go before it sets its final high. It is difficult for investors to adopt a defensive approach when the economy continues to perform and earnings look set to go on growing.
For our part, we note that most stock markets are still below last year’s highs and about at the same level as 12 months ago. Price-to-earnings multiples are reasonable and no longer as extended as they were in early 2018. We have been impressed by the power and breadth of the liftoff from the ultra-depressed December low point. We expect new highs lie ahead for the U.S. broad averages and for most developed economy stock markets.
We are content for now to maintain our benchmark target weight (Market Weight) exposure to stocks in a global portfolio. However, we are treating the inversion of the yield curve as a “shot across the bow” for equity investors. We expect to counsel the adoption of a progressively more defensive posture over the course of the next six to 12 months.
Non-U.S. Analyst Disclosure: Jim Allworth, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.