Is a recession inevitable?

The yield curve has been a constant topic of conversation among investors
since mid-August, when the 2-year/10-year Treasury curve briefly inverted and
launched furious speculation that a recession may be around the corner.  The same holds true among Invesco’s market
strategists, who have been debating what an inverted yield curve means and whether
a recession is indeed inevitable.

Below, Brian Levitt, Invesco’s Global Market Strategist for North
America, and Talley Léger, an Invesco Investment Strategist who specializes in
the equity markets, compare their views on the state of the markets today.

markets fulfilling their own prophecy?

Brian: Did the yield curve inversion keep
you up at night?  Let’s be honest, it’s been a pretty
good signal
of recessions in
the past.  I’ve always told investors that recessions are the results of
policy mistakes, and that I expect an inverted yield curve to be the first
visible symptom of such a policy mistake.  Trade uncertainty seems to be
grinding business investment to a halt.  Yet, every ounce of my being is
telling me that this would all change with a shift in tone from the Trump administration.

Talley: Admittedly, the yield curve inversion
did concern me. I seem to recall at similar points in past cycles that at least
one pundit dismissed the efficacy of the yield curve as a business cycle
indicator, which ultimately proved to be a slippery slope. As responsible
stewards of capital, I think we’re right to at least consider the rising risk
of recession.

In my view,
the ebb and flow of cycles is only natural, whether it’s the changing of the
seasons, sunrise and sunset, tidal forces, the rhythm of our bodies, or the
waxing and waning of economic activity. From that perspective, the next
business cycle contraction isn’t a matter of “if” but “when.” Encouragingly, as
of late August, four of the five business cycle indicators I monitor were above
their respective median readings at the onset of economic recessions since
1948. (By the way, the infamous yield curve is a component of two of those
indicators.) In other words, it may be too soon to sound the recession alarm.

Are inverted
yield curves symptoms of policy mistakes? Perhaps. A more philosophical
question is: “Do inverted yield curves themselves actually cause recessions?” For the sake of argument (and this post), I’ll
play devil’s advocate. Consider that the US economy is largely finance-based.
An inverted yield curve creates a disincentive for banks and other institutions
to take risk and lend. Without a healthy flow of credit — the lifeblood of an
economy — activity can slow or grind to a halt. To what degree are we
fulfilling our own prophecy?

Brian: “Sunrise, sunset, swiftly go the
days.”  As a proud descendant of grandparents who fled the shtetls of Byelorussia, I welcome that
reference — but I don’t agree with it.  Recessions don’t have to
happen.  They are not like the rhythms of our bodies.  Business
contractions are the result of bad policy, plain and simple.  You do,
however, make a good point about fulfilling our own prophecies.  I recently
read that Google searches for “recession” are at their highest level since

My point is
that the yield curve inverted because of policy mistakes — last year’s Federal
Reserve tightening and the ongoing uncertainty around trade.  In that
sense, it is a symptom — not the cause — of recent economic
deterioration.  But you’re right; if it persists, it would not be positive
for growth.  I miss the days of 2% growth, 2% inflation and policy
certainty.  Where have you gone, 2017? 

Barring a
policy mistake, this decade-long cycle could continue to go on for far longer
than most suspect.  I still believe it will.  It seems unlikely to me
that the Trump administration will want to go into an election year with
leading economic indicators deteriorating to this extent.  I’m happy that
your leading indicators are above median, but for how much longer?  And is
it too late to get defensive?     

Talley: I agree that policy is set by human
beings, and humans are prone to error. What are markets and economies? They’re
organic, complex systems composed of fallible human beings. As such, the
economy has a rhythm, just like us. To quote the philosopher George Santayana:
“The earth has music for those who listen.” To clarify, I’m not arguing that
contractions must happen. I’m simply
making the empirical observation that they do.
Alternatively, we could make the same argument based on physics and economic
gravity. What goes up eventually comes back down.

Why are we
debating the length of the current economic expansion? Because the business
cycle shapes and guides the performance of stocks relative to bonds, and
cyclical equity sectors relative to their defensive counterparts. In the near
term, uncertainty and stock market volatility related to heightened trade
tensions have asymmetrically punished global cyclicals, given related headwinds
to worldwide exports/imports and economic growth. While defensive sectors have
outperformed on a year-over-year basis, the bulk of the move seems to be behind

defensive sector outperformance to persist would be consistent with bonds
continuing to outperform stocks and akin to making a recession call, which I’m
unprepared to do at this stage. In the long term, I believe a potential trade
deal would remove associated concerns about global growth, and that investors
who stick to their plan would likely be rewarded for their patience.

Brian: Santayana also said, “Those who do
not remember the past are condemned to repeat it.”  Trade wars are as old
as time.  The theft of intellectual property was a staple of US economic
strategy in the years after the nation’s founding.  The Entente and the
Central Powers fought WWI, in part, for trade supremacy.  They repeated this
fight 20 years later.  I much prefer the “trade wars” of the 21st
century.  While protectionism results in inefficient economic outcomes,
such as higher prices for consumers, it doesn’t necessarily cause
recessions. It’s the uncertainty
of it all that’s worrisome. 

Still, you
may be right.  It may be too late to get defensive.  The 10-year Treasury
rate is already below 1.5%.  The utility sector is already up 20% this
year.  It feels like this could be a repeat of early 2016 where a
redirection of policy — this time from the administration’s trade
representatives rather than the Fed — could be the catalyst for the cyclical
sectors to regain their leadership. 

James Carville — the political advisor behind Bill Clinton’s
presidential campaign rallying cry: “It’s the economy, stupid” — once said that
he wanted to be
reincarnated as the bond market, so he could intimidate everyone.  Carville
is still with us, but the yield curve is inverted and investors are feeling the
pressure.  Will the administration be intimidated?

Talley: We spend a lot of time worrying about
foreign policy, but maybe we should give the US economy, its consumers, and its
businesses more credit for their resilience and dynamism. Together, they
constitute almost 90% of gross domestic product (GDP), whereas the government
represents less than 20% of the economy.1

To be clear,
I’m not dismissing the inverse relationship between economic policy
uncertainty, which is elevated, and business spending growth, which is
depressed. Logically, a highly uncertain policy environment and increased costs
in the form of tariffs are delaying businesses’ decisions to spend and invest.
My point is that households are in good shape at a time when we’re seeing a
rapid policy response from central banks around the world, including the
Federal Reserve.

the current US expansion began in June 2009, and is now the longest cycle on
record, sustained by low interest rates, disinflation, and moderate real
economic growth. True, trade wars and tariffs are downside risks to the
economic outlook. However, global monetary policymakers are doing what they can
to ensure the global expansion continues, albeit at a slower pace. In order for
this cycle to meet an untimely demise, there would have to be a massive
disruption in China or the US, neither of which appears likely to me given the
current mix of accommodative policies from their respective central banks.

What about
international markets? The US-China trade war has been a significant headwind
for Chinese and emerging market stocks. Given the Trump administration’s
Twitter diplomacy, however, it’s reasonable to expect that trade risks could be
toggled off with a tweet. If that happens, I believe that investors with no
exposure to Chinese and emerging market stocks would miss a likely inflection
point in those markets.

Brian: A nice contrarian view on emerging markets and China!
 I certainly see value in those markets. I’ll cede to you that final

1 Source: Bureau of Economic Analysis, 7/26/19.


Blog header image:
Captivating Media / Unsplash

An inverted yield
curve is one in which shorter-term bonds have a higher yield than longer-term
bonds of the same credit quality. In a normal yield curve, longer-term bonds
have a higher yield.

A cyclical sector’s performance tends to be affected by ups and downs in the overall economy, while a defensive sector’s performance doesn’t tend to be highly correlated with the larger economic

The opinions referenced above are those of the
authors as of Sept. 10, 2019. These comments should not be construed as
recommendations, but as an illustration of broader themes. Forward-looking
statements are not guarantees of future results. They involve risks,
uncertainties and assumptions; there can be no assurance that actual results
will not differ materially from expectations.


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