The global economy isn’t firing on all cylinders right now. In recent months, economic data out of the eurozone, UK, Japan, China and (less so) the US have weakened and even occasionally contracted. To investors wondering whether worse is to come, we have a message: Weak patches aren’t necessarily self-fulfilling prophecies. Mid-cycle slowdowns—short stretches of slower growth during a longer period of economic expansion—happen regularly and often precede reacceleration and more bull market. In our view, that is where we are today.
Setting aside US industrial production, which jumped and beat analysts’ estimates in August, headlines today allege myriad troubling trends: China’s factories and consumers are floundering as industrial production and retail sales slow; Brexit is weighing on Britain’s economy; Germany teeters on the edge of recession as its manufacturing juggernaut stumbles; the eurozone is slowing overall; and an upcoming consumption tax hike is about to add another headwind to Japan’s weak domestic demand. All this raises a question: Is this a mere soft patch or the early stages of a global recession?
In our view, the former is far more likely. Recent weakness shares several features with the slowdowns earlier in this expansion—2011 – 2012’s and 2015 – 2016’s. All three have featured global recession worries, due first to the eurozone crisis, then trouble in oil-reliant economies, and now tariffs and Brexit. Like today, 2011 – 2012 featured GDP contractions in select major economies, including Germany, Spain, France, Italy, the US, UK and Japan. Some, including the eurozone, endured recessions. Also like today, 2015 – 2016 featured contracting manufacturing across much of the globe. All three slowdowns have featured a decelerating US Leading Economic Index (LEI) and global stock market corrections—sentiment-driven declines of around -10% to -20%.
Beyond specific parallels, we see one overarching theme tying all three slowdowns together: Sky-high fears about negative developments that weren’t large enough to send the global economy into recession. After a while, the fears faded and the bull marched on. We think the same is likely today.
Granted, in the last two slowdowns, folks could point to positive forward-looking indicators like an upward-sloping yield curve, whereas today the US yield curve is inverted. But in addition to the yield curve’s poor record as a timing tool, we see other reasons to question whether today’s modestly inverted curve necessarily signals trouble. Anecdotal evidence suggests banks are trying to lend more, not batten down the hatches—an indication inversion hasn’t choked off credit.
We also wouldn’t dismiss the possibility of inversion reversing. Unlike several past inversions, which stemmed from central banks hiking short-term rates, the current one is mostly attributable to long rates falling a ton over the past year. That stems in large part from a flight to safety as investors fearing economic problems seek stability in bonds, bidding prices up and yields down. In our view, the slow growth fears suppressing long-term bond yields may fade as the global recession and bear market many fret today don’t materialize. Take all short-term movement with a grain of salt, but 10-year Treasury yields rose from 1.46% to 1.84% since September 4, helping ease the negative interest rate spread from -0.51 percentage points to -0.15.[i] It wouldn’t take much from here to turn the curve positive—a possibility we haven’t seen discussed in broader financial news. Other yield curves, including the UK’s and Japan’s, also inverted this summer but have reversed in recent days. Ditto the global yield curve. The functional distinction between slightly inverted and slightly un-inverted is meaningless, but the unheralded improvement seems noteworthy from a sentiment standpoint.
We see other reasons for investors to take heart. Economic conditions are one of stocks’ main drivers. But stocks aren’t the economy. Stocks move on political developments, too—plus, crucially, how sentiment compares to reality in both arenas. As we wrote in our 3/25/2019 commentary, “10 Years of Slow Growth Fears,” this helps explain why the bull market has chugged along through similar soft patches. Slow growth’s big silver lining, in our view: It depresses investor sentiment. This keeps euphoria—a common bull market killer—at bay and raises the likelihood of positive surprise. When doom-and-gloom outlooks abound, stocks can rise even without a major economic resurgence. Just a middling but better-than-anticipated reality should do.
To us, this underscores the importance of hanging tight when economic and market turbulence hits. If your long-term financial goals still require equity-like returns, mid-cycle slowdowns like the current one change nothing, in our view.
[i] Source: FactSet, as of 9/17/2019. 10-year and 3-month US Treasury yields (constant maturity), 9/4/2019 and 9/16/2019.
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