When the U.S. sneezes, the world catches a cold. And at the moment, the US is decidedly sniffly.
Last quarter saw the world’s largest economy shrink instead of grow, and there are other signs that a recession could be nigh. And of course, a recession in the world’s largest economy, which also happens to house the world’s biggest equity and fixed income markets, will impact investors wherever they are.
According to T. Rowe Price, there are three measures that have, in the past, been reliable indicators of recessions in the U.S. The first is a surging oil price, tick. The second is the central bank raising interest rates, tick. And the third is the inversion of the Treasury yield curve, tick.
For those I’ve lost with that last sentence, it basically means that when short term interest rates are higher than the market thinks long term interest rates will be, the U.S. government bond graph shows a downward slope.
Let’s take a closer look at each of these three indicators.
Nearly every U.S. recession since the mid‐1970s has been preceded by a sharp rise in oil prices. “These days, the world economy is less dependent on oil and uses fossil fuel more efficiently, but the oil price still matters greatly to firms and individuals because it impacts prices in so many other areas, such as manufacturing, consumer goods, household energy bills, and car fuel to name but a few,” said Yoram Lustig, head of multi-asset solutions at T. Rowe Price.
“A higher oil price leaves consumers with less discretionary income. It may also lead to inflationary pressures and tighter monetary policy, which could result in an economic slowdown.”
“Economic expansions do not die of old age—the Fed kills them,” said Yoram Lustig. When tightening monetary policy, the Federal Reserve (the US central bank) aims to slow economic growth to tame inflation but not so much to topple the economy into recession.
PIMCO’s Allison Boxer commented last week: “The Federal Reserve managed to deliver the largest rate hike since 2000 while at the same time surprising market expectations somewhat on the dovish side.
“The main news from the press conference was that Chairman Jerome Powell pushed back on the 0.75% hikes that markets had started to price in. While the statement focused only on inflation risks and Powell underscored that the Fed is squarely focused on getting inflation back to target, he also acknowledged that the Fed needs to be nimble as it navigates incoming data. This is consistent with our view that an “expeditious” pace of rate hikes will continue as the Fed uses the summer to quickly reverse pandemic era rate cuts, but ultimately will need to be “nimble” in navigating downside risks to growth.”
Yoram Lustig added: “Since 1976, the Fed has only twice succeeded in hiking rates without pushing the U.S. economy into a recession in the following couple of years—in 1983 and 1994. Only time will tell whether the Fed’s latest hiking cycle will succeed in combating inflation without a recession—or if a recession will be needed to kill inflation.”
The slope of the yield curve (U.S. Treasury 10‐year yield less two‐year yield) is the classic harbinger of a U.S. recession.
The short end of the yield curve reflects market expectations about short‐term policy interest rates over the next two years; the long end of the curve mainly reflects market expectations about inflation and economic growth over the next 10 years.
“When it costs more to borrow money in the short term than it does in the long term, the yield curve slopes downwards – that is, it inverts,” said James Malony, fixed income specialist at Schroders. “At best, an inversion suggests that investors expect the economy to slow, at worst it signals a recession could be on the way.”
“Inversions preceded each of the six recessions since 1976,” added Yoram Lustig. “The yield curve inverted again in March of this year, albeit with the long end of the curve already pushed down by unconventional monetary policy.”
Before we answer that question, it’s worth remembering that the economic cycle goes through periods of boom and bust and recessions are a part of the cycle, bringing economic hardship but also constructive destruction.
“Based on our key indicators—the oil price, Fed policy, and the slope of the yield curve—a recession in the U.S. seems increasingly likely,” said Yoram Lustig. “However, history shows that these signs have typically preceded a recession by about an average of two years. Investors should closely monitor developments while dynamically adjusting their portfolios as conditions change.”
Richard Woolnough, manager of M&G Corporate Bond and M&G Optimal Income fund added: “In order to suffer the economic consequences of recession, we need to have an increase in unemployment. But it is pretty clear that we have a long time to go before that happens. Given this compelling evidence, I would argue that a recession is not around the corner.
“The economy will slow as the Fed tightens monetary policy, working with its usual delay. Economic growth will also be limited as being at full employment potential growth is (by definition) curtailed by the lack of supply of labour.
“But from my perspective I think that recessionremains unlikely in the near term. This means monetary policy can continue to be tightened, and credit does not need to price in a default cycle in the near future.”
Mark Holman, Partner at TwentyFour Asset Management, whose Corporate Bond and Dynamic Bond funds are on the Chelsea Selection and Core Selection respectively, said: “As this remarkable cycle rapidly progresses, thoughts have more recently turned to the chances of a U.S. recession in 2023, and whether the Fed can somehow pull off a soft landing.
“Historically it has taken as little as nine months and as long as nearly four years to appear, so while the reliability of the outcome can’t be denied, the timing makes it impossible to use as anything more than a warning signal.
“When the yield curve inverted in August 2019 and a recession followed in March 2020, no one had even heard of COVID-19. The inversion was correct as usual, but the recession that followed occurred for reasons that could not have been predicted.
“In our opinion, a soft landing in the US is still more likely than a hard landing, but it is clear that inflation is more persistent and at higher levels than the Fed has previously guided, which means a series of rate hikes is inevitable – and at a hiking pace that markets have not recently been accustomed to. It’s also clear that the US consumer has already endured a tough 12 months of inflation, which will have impacted spending power.
“These conditions look set to continue throughout 2022, and it comes at a time of sharply rising rates. Consequently, it feels inevitable again that consumer confidence will be eroded. For a consumer driven economy like the US this is not good news, and therefore we have to factor in a reasonable dent to previously forecasted GDP growth.”
Emiel Van Den Heiligenberg, head of asset allocation at Legal & General Investment Management concluded: “History shows that most US Federal Reserve-tightening cycles end in recession. However, we believe the risk of a recession in the next 12 months remains relatively low, given the starting point of above-trend growth, a strong housing market, large excess savings and less capex build-up than normal.
“We also believe the next recession will be relatively mild because there are fewer fundamental imbalances to unwind beyond the inflation problem. We do not think we are in a 2008-like credit crisis, or an excessive valuation environment like in 2000. We expect a classic cycle end: an ‘old-fashioned’ recession.”
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