This article appears as published in the Globe and Mail and Rachael Moir is the byline.
Trade tensions, the risk of monetary policy error, Brexit developments, and disappointing U.S. job creation in May are all valid reasons to fear a recession is in the making. The inverted U.S. yield curve is telling us just that after all. Or is it?
In my view, it isn’t the case. Our team still expects the U.S. and Canadian economies to grow, albeit moderately, which means growth concerns, while not unwarranted, are overdone.
Recession fears could drive down the U.S. 10-year yield even further
Investors are faced with conflicting signals from equity and bond markets: the former reflect continued economic expansion, while the latter reflect fear of a recession.
The S&P 500 has posted double digit returns year-to-date and despite a spike in Treasury volatility over the past month, the VIX, a measure of expected market volatility, has remained around a level of 15, relatively subdued compared to the fourth quarter of 2018. The U.S. 10-year benchmark yield fell below the 2 per cent mark recently, a sharp decline from 3.2 per cent in October 2018, reaching its lowest level since November 2017.
Recession fears and the search for yield and a safe haven could drive the U.S. 10-year yield even lower before it recovers. Our models currently estimate the fair value at 1.55 per cent.
Our fair value estimate started to pull back in January 2018 when the JPM Global Manufacturing PMI posted its first drop in what has become a sustained decline. It has now fallen below the 50 mark into contractionary territory, reaching 49.8 in May.
But recession fears won’t materialize
Yet, the PMI did fall below 50 in 2011, 2012, and in 2016, without preceding a recession. These instances coincided with mid-cycle economic slowdowns, the most recent resulting from the industrial deceleration in China.
If the Global PMI stays low and the U.S. dollar stays strong, then our fair value estimate would remain low.
But we don’t expect that scenario to materialize. As PMIs are correlated with economic growth, and GDP data show ongoing expansion, we expect a near-term pick up in PMIs from here.
First, much of the current recession fears have been driven by expectations – soft data like surveys and market indicators dampened by geopolitical risks – rather than hard data.
There is no denial that expectations can become self-fulfilling and slow the economy. This is why the Fed will have to act on growth fears even if the latter are overdone.
Second, our U.S. bear market indicator is still signalling a low probability of a recession coming. It also shows that the components that are raising concerns are more related to capital market indicators (especially interest rates) than economic indicators (growth, inflation, corporate earnings). Indeed, the U.S. economy grew 3.2 per cent in the first quarter, and Canadian GDP growth was 1.4 per cent.
In our view, negative headlines related to trade talks are overshadowing positive factors. The U.S. economy is still solid, so a rate cut from the Fed would otherwise not be necessary. Still, the tone at the latest Fed meeting was very dovish and the likelihood of a rate cut in July is very high. The market is certainly expecting the central bank to lower its policy rate now and not delivering on this could lead to an unwinding of expectations and a spike in market volatility.
If stock markets did experience another sell off, the Fed would be forced to cut rates. Given the current environment of low growth and inflation, a Fed interest rate cut at this time would pose little to no risk of activity and inflation overheating. It would also prevent the U.S. dollar from appreciating too much and constraining global financial conditions.
We remain tilted towards risk assets
With the U.S. growth slowdown unlikely to turn into a recession, we still favour equities over bonds, although to a lesser extent than earlier this year.
Within fixed income, we have extended duration in our U.S. credit portfolio and maintained our allocations to U.S. investment grade and high yield. While credit spreads have widened recently, it’s mainly due to the rally in U.S. Treasuries, which creates a good opportunity to invest in credit products.
With the Fed adopting a more dovish tone this month and likely to cut rates in July, growth expectations, and therefore the U.S. 10-year yield, will rebound over the second half of this year. Developments in the trade dispute and incoming economic data will be key to monitor.