MODEST LOSS: For the week, stocks notched a modest loss. Although the end result was rather boring, it was nothing but boring on the way to a week with less than a 1% loss in the S&P 500. On Wednesday, stocks had their worst day all year. The reasons were the yield curve inversion (more on that below) as well as some relatively weak data coming out of Germany and China. The day before this bad day, the markets had a great day in response to optimism on China/U.S. trade tensions. After Wednesday, stocks bounced back, but not enough to prevent another (third in a row) negative week.
YIELD CURVE INVERSION: AN EXPLANATION: What is the yield curve, and why is it a concern for the markets? The yield curve is simply a comparison between the yields you can earn if you buy a short-term bond compared to buying a long-term bond. The normal shape of the curve between short-term and long-term is upward sloping. Yields generally increase as maturities get longer. The slope is “inverted” when long-term yields fall below short-term yields. If the curve is inverted, it is said to reflect expectations that the economy is weakening. When the yields you can get on a long-term bond you buy on the open market is less than the yields you can get on a shorter term bond, it has long been viewed as a precursor to a recession. It essentially indicates that too many people have more confidence in the short term than the long term, meaning a recession is going to happen in the interim.
WHAT HAPPENED LAST WEEK?: Last week, the yield on the ten-year U.S. Treasury fell below two-year yields for the first time since 2007. This set investors on a day of selling. This signal has been a reliable predictor of a recession within the next 21 months. Is “this time different?” Those are always dangerous words, but it is always worth examining what is different about the current environment. Certainly, the level of global central bank activity (the U.S. Federal Reserve, the European Central Bank and others) in keeping interest rates low is unprecedented. Did the yield curve invert because of the Fed’s activities in buying bonds? Also, bear in mind that recessions and stock market activity do not always coincide, and they never act in lock step with one another. While an inverted yield curve may mean a recession in the next one to three years, it does not mean it will be easy to time the markets. It also says nothing about the severity, or lack thereof, of the recession. Our closest point of reference is the Great Recession, and so many people hear the word “recession” and think about that recession, and panic sets in quickly. What if it is more of a “normal” recession?
Another odd thing historically is that the 10-year vs. 3-month yield inverted early this year. Last week the 10-year vs. 2-year inverted. Generally, the sequence has been the other way around, so this cycle is not following the normal pattern.
Finally, keep in mind that the inversion was momentary. As I’ve said before, watch for it to stick for it to be a better predictor.
And, watch for these conditions that historically have preceded recessions:
- Rising interest rates
- Rising inflation
- Credit squeeze
- Asset bubbles
- A Fed policy mistake
While none of these seem to be in place, the trade war activities could be a government policy mistake that triggers a recession. We and many, many others continue to watch all of this data in its historical context very carefully.
GERMANY’S ECONOMY STALLS: The German economy shrank in the second quarter, barely. Germany’s GDP contracted by 0.1%. The dip was blamed on the slowing of its exports caused by the U.S.-China trade war as well as prospects of an abrupt Brexit.
WE ARE SPENDING: Meanwhile, U.S. consumer spending was quite healthy in July. Concerns over weakening economic growth and trade wars did not impact spending. Retail sales rose 0.7% in July after a 0.3% gain in June.
PRODUCTIVITY PICKING UP: This very long (now over 10 years) recovery has been marked by historically weak U.S. productivity. This recovery has seen productivity growth at about 2/3 of its historic average. Greater productivity is a key to raising living standards as it enables companies to increase worker pay without raising prices. In the last quarter, productivity grew by 2.3% (annual rate) after a 3.5% increase in the first quarter. So far in this recovery, the average annual increase has been 1.3%.