Rumors of the Market’s Demise Have Been Greatly Exaggerated

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by Timothy D. Carkin, CAIA, CMT
Senior Vice President

On Wednesday at midday, the global financial media held their collective breath as the benchmark U.S. Treasury Yield Spread (2-year/10-year yield) inverted. Then, as they exhaled, minor hysteria ensued. The following day, headlines like the ones below emerged to explain the inversion. As of this writing, the 2-year/10-year spread is positive by five basis points.

Source: Strategas

Source: Strategas

Historically, an inverted yield curve has been a good predictor of the U.S. economy entering recession within two years. To be consistent, the 2-to-10-year spread has been used for that indicator. But with these headlines flashing for a two-day event, it’s easy to forget that the 3-month/10-year spread has been inverted since May. The “Doom and Gloom” headlines were merely dusted off again for this inversion.

History Doesn’t Repeat Itself, but It Rhymes

In the last year, this blog has discussed an inverted yield curve seven times. We’ve talked about it at our Investment Outlooks, in our Market Letters as well as in our quarterly Investment Strategy Videos. Except for the 1998 inversion, most recent recessions have been preceded by a yield curve inversion. So logically, in the later innings of a long expansion, we take the signal seriously.

The inversion signal gives a long window for the recession to start. The table below lists the S&P 500 Index returns after recent inversions. During these previous events we can note that equity markets have shrugged off the inversion and continued before peaking.

Sources: LPL Research, FactSet. December 4, 2018

Sources: LPL Research, FactSet. December 4, 2018

While the inversion in the yield curve appears to be a canary in the coal mine, it is only one indicator we consider when looking for signs of a recession. Slowing global growth, weakening effects of monetary policy and uncertainty surrounding trade align with the warnings of this signal. But we can’t discount the near 50-year-low in unemployment, wages and salaries up 5 percent again this year and a healthy 8 percent household savings rate. These aren’t typically data points that indicate a recession in the near-term. Importantly, our economy is largely consumer-based; therefore, we would expect signals of a weakening consumer to confirm that a recession is on the horizon. Seeing none, the yield curve inversion may have raised our antenna, but the economic expansion will continue for the time being.

Week in Review and Our Takeaways

  • Volatility remains in the equity and fixed income markets as trade and economic data continue to paint a late-cycle picture

  • Recession fears elevated as the 2-to-10-year yield curve inverted