Inversions and Potential Recessions

By Ketu Desai

There was no August slowdown for markets, as the bond market drove a volatile month. For the most part, on days yields dropped, equities dropped, and vice versa. Yields across the curve plummeted with the 30-year trading below 2 percent and the 10-year below 1.50 percent during the month. The rush into fixed income, caused an inversion of the important 10s/2s spread. Historically inversions have preceded recessions, however, not every inversion has predicted a recession. While the yield curve is an important indicator, it is very possible that the inversion was caused by technical factors, rather than fundamental factors, such as negative yields across Europe and Japan, relative US economic strength, relative US yields, and distortions due to quantitative easing and monetary policy. Further, Canaccord Genuity points out that the median gain in the S&P 500 from the initial inversion to cycle peak is 21 percent, with recession occurring a median 19 months after the initial inversion.

Recession fears notwithstanding, growth estimates for the quarter are up, now 2 percent, and for the full-year will likely be in the low/mid-2 percent range. The consumer makes up 70 percent of the economy, and until it exhibits weakness, recession odds remain contained. That said, we may already be in a global manufacturing recession, which I believe stems from China. The economic data out of China continued to come in weak this month, with industrial production coming in at the slowest in 17-years, weak fixed asset investment, and retail sales. The weakness in China, also shows up in the export-driven German figures, which showed that its economy contracted last quarter.

With recession fear taking hold, policy makers are attempting to be pro-active. According to top ECB officials, they will announce a “big bazooka" in September, which could include further rate cuts, a restart of quantitative easing with the possibility of it being open-ended, and sweetening loans made within the TLTRO program. Further, European governments may finally be opening up to taking advantage of their negative rates to help stimulate their economy. Germany's Finance Minister Scholz, said that Germany could spend an extra $55 billion to stimulate the economy. In China, the PBOC reformed its interest rate system with the goal of reducing financing costs to help stimulate their economy. Other Asian economies also cut rates during the month, including, India, New Zealand, Thailand, and Philippines. Finally, comments from Chairman Powell at the Fed's annual Jackson Hole gathering appear to be teeing up another rate cut in September. While these actions are supportive, they do little to mitigate the core issue plaguing the economy, the trade war, the seemingly daily changes are effectively freezing decision-making for many investors and corporations, which in turn is halting economic growth.

With $15 trillion in negative yielding debt, US Treasury yields near all-time lows, and an equity market mostly driven by defensive sectors, are we reaching a point where defensive assets are too expensive for long-term investors? Negative yields could certainly get more negative; however, it feels like buying these assets relies too much on the greater fool theory. While there is certainly room for yields to continue falling domestically, real yields across most of the US yield curve are now negative. A move back to yields late last year would cause roughly a 15 percent loss for the 10YR. The S&P dividend yield is more than that of the 30YR, and the S&P earnings yield is more than 4 percent greater than the 10YR. At the sector level, the utilities ETF trades at 23.1x, the same level as the faster growing tech ETF, and 5x greater than the broader market. Similarly, the REIT ETF trades at 2.6x book value, when top financial institutions such as Bank of America, Goldman Sachs, and Citigroup trade at 1.0x, 0.9x, and 0.78x book, respectively. Further, there are defensive names such as Clorox that trade at 23.8x, when Google, Microsoft, and Facebook trade at 21.0x, 22.7x, and 19x, respectively.

Looking forward, the markets will be focused on the next round of trade discussions with China, and important Fed and ECB meetings.


Ketu Desai is the Principal of i-squared Wealth Management Inc. ( ), an investment management firm based in New Jersey.