There are varying reports in the media about how bleak the economic future is. Taking one example, the Daily Mail wrote in September and October of 2018 that "Britain is on the verge of a recession"(1), while the next recession is "expected to hit the United States within the next two years"(2). The newspaper is by no means alone in focusing on a narrow range of data and opinions to populate such articles.
Let’s look at the facts. The outlook for global economic growth over the next 12 months or so is positive although slightly less optimistic than it was for 2018. This also applies to the UK with the OECD predicting a slight downward adjustment from 1.3% to 1.2% of annual growth for both 2018 and 2019(3). It might be slower, but it is still growth.
The US economy is the world’s largest and it has led the financial and global recovery since the financial crisis 10 years ago. The indicators for the US remain moderately positive for the first half of 2019, though this could tail off during the year. The outlook for the manufacturing sector hit a 17-year high in September 2018(4) while there was a net increase of more than 200,000 jobs and a substantial rise in wages reported by the US Labor Department in August.
However, the OECD’s composite leading indicator for the global economy is suggesting that economic growth could be about to falter, even though it nudged upwards in September. So if there is to be a downturn, how soon might it be?
One of the more reliable indicators of a looming recession is what’s known as an inverted yield curve.
Normally, the yield or return for holding a bond tends to be higher the longer the remaining life-span of the bond. This is because over time, the risk of increasing inflation or interest rates rises and that eats into the value of a bond. So we would normally expect the yield on the US 10-year Treasury (government bond) to be substantially higher than that of the 3-month Treasury.
If the demand for a bond rises, its price rises but its yield falls. This also works in reverse: if demand and prices fall, yields rise. At the time of writing in November 2018, the yields on 10-year Treasuries had recovered to exceed their 2013 levels in response to the pick-up in inflation and US interest rates.
Our analysis suggests that the 10-year Treasury yield is likely to reach 3.3% in the middle of 2019(5) and remain there for at least the following 12 months. This is because further interest rate rises (which would push yields up) at that point will be harder to justify as borrowing would become more expensive for US residents. That would reduce demand and slow economic growth.
The significance here lies in the fact that we expect the 3-month interbank borrowing rate also to reach 3.3% in mid-2019 and stay there. In other words, there is a strong chance that the 10-year and 3-month rates could converge, and that often leads to an inversion (where the 3-month yield rises above the 10-year yield).
In the US, the time between the 3-month and 10-year yields being within 0.5% of each other and then inverting (the 3-month yield rising above the 10-year yield) averages five months(6). The difference between the two yield curves is currently around 1%, so we can’t even start that clock yet. If the yield curves were to invert, the average time from inversion to a recession is a further 17 months(7). That ought to take us into 2020, from which time the outlook is less assured.
There are other sources of data suggesting much the same story. Purchasing managers’ indices (PMIs) indicate if purchasing managers experienced a fall or rise in demand over the preceding month. By collating responses from several hundred purchasing managers, the respective index gives an indication of falls or rises in metrics such as sales and inventories.
Individual PMIs focus on industrial sectors such as manufacturing, services and construction in separate countries. When completed, these can be compiled to form the composite PMI for a given country. The range of numbers on a PMI reading is from 0 to 100 where anything above 50 indicates expected growth while below 50 suggests expected contraction.
In late 2018, the composite PMIs of the world’s four largest national economies had been above 50 for almost two years. Those of the US and Japan were showing signs of dipping but still remained in expansion territory at the time of writing.
This will not have escaped the attention of the central bankers who are charged with managing interest rates and the availability of money in order to keep inflation and economic growth under control.
In the meantime, actions currently being implemented by major central banks across the globe, such as interest rate rises and reductions in bond-buying programmes, are causing the amount of money flowing through the financial system to fall at its fastest rate since 2008(8). If there’s less money, prices tend to go up, demand tends to go down and that reduces company earnings and economic growth. This could lead to fewer interest rate rises and, therefore, less support for the value of the dollar relative to other currencies because the US is ahead of other central banks in terms of its reversal of stimulus.
What’s more, as some central banks reduce their role in buying bonds and, in the case of the US central bank, slowly sell the trillions of dollars of bonds that they have accumulated over recent years, the overall demand for and prices of bonds are pushed down. High bond yields can attract investors out of high-rated stocks and this contributed to the sharp stock price falls that we saw in February and October. This phenomenon could give rise to further price volatility in the future.
Despite this being the case, the appetite for risk among investors appears to be extremely high. For example, CrossBorderCapital described their own World Investors’ Risk Appetite index as standing at "an eye-watering 33.2". This index has a range of between -50 and +50, with anything above zero indicating a general desire among market participants to buy higher-risk rated investments.
Distilling this information, the indicators suggest that, notwithstanding investor hubris, growth is likely to slow somewhat but we are far from foreseeing a recession in 2019. However, the negative influences that we have touched on above could combine to create a "wall of worry", eroding confidence and growth. These influences include reduced central bank stimulus, the changing yield curves on bonds, trade tensions, above-target inflation, slowing global economic growth, elevated equity prices and rising debt levels.
With all of these in mind, we would not be surprised if corporate profits or "earnings" were to fall. We address this topic in a separate article in this series.
Also, hear the views of Markus Stadlmann, Chief Investment Officer, Wealth on this topic as part of our Outlook for 2019 series of films.
1. “Experts warn next recession will hit US within two years”, Daily Mail, 23 September 2018.
2. “Britain ‘on brink of recession’”, Daily Mail, 2 October 2018.
3. Source: September 2018 Economic Outlook, OECD, September 2018.
4. Source: ISM Manufacturing index reading of 61, widely reported, 4 September 2018.
5. Source: International Financial Outlook, Lloyds Bank Commercial Banking, 7 November 2018.
6. Source: “Three frequently asked questions about global yield curves”, BCA Research, 31 July 2018.
7. Source: “Three frequently asked questions about global yield curves”, BCA Research, 31 July 2018.
8. “Global liquidity latest: World central banks tightest for three decades…global liquidity skids by most since 2008”, CrossBorderCapital, September 2018.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at January 2019.
Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
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