InvestmentsDec 17 2019

Recession or no recession?

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The global economy appears finely balanced.

While economic data has softened and the bond market is hinting recession, a shift in interest rate policy may yet act to prolong the expansion.

Is a recession imminent? Or can the business cycle continue?

The indicator that has investors particularly worried is the yield curve.

An inverted yield curve is not necessarily a sign of imminent recession – it depends on why it is happening

The US yield curve did temporarily invert in the summer meaning short-term rates are higher than long-term rates.

Historically, this has been a sign of recession, though with a lag of up to 18 months.

To our mind, an inverted yield curve is not necessarily a sign of imminent recession – it depends on why it is happening.

If long-term rates are lower than short-term rates then this is normally because investors are expecting that short term rates will need to drop over the longer term.

Often short-term rates will have spiked because central banks have been forced to push up rates in response to an inflationary threat – and central banks have a poor track record on raising rates without causing a recession.

This time, long-term rates are depressed because lower interest rates have prompted unprecedented demand for longer-dated bonds.

Pension funds, central banks, insurance groups are all buying longer-dated paper.

Progressively, this higher demand has pushed up prices and pushed down yields.

In the meantime, short-term rates were rising as part of a policy normalisation, rather than responding to an inflationary threat.

As this reverses, quantitative easing resumes in much of the developed world and the US is taking an accommodative stance to interest rate policy; so we are already seeing the yield curve revert to a more normal pattern.

In this way, we believe that perhaps this time, it may not be deterministic.

Nevertheless, there are some worrying signs among the economic data.

Trade war

The trade war has had its casualties far beyond China and the US.

Germany is perhaps the most notable.

The September reading for German manufacturing data showed its worst print in more than a decade (rising 30 basis points in October) and there has been real weakness across the Eurozone and in export-focused Japan.

That said, there are other reasons for the weakness in German manufacturing.

It is particularly reliant on the car industry, which is in the grip of a major structural transformation as diesel engines’ halos have slipped, the combustion engine is losing its pre-eminence and electric cars gain modest popularity.

German unit labour costs have also increased significantly, which has weakened the country’s manufacturing competitiveness.

Elsewhere, data is coming under pressure, but perhaps not as savagely.

In the US, consumer data is still relatively buoyant. October retail sales data in the US reversed the 0.3 per cent drop in September, gaining 0.3 per cent.

Weakness in car sales continued in October, deepening the fall in sales the industry has experienced over the past three years.

This should be helped by falling interest rates.

US mortgages are generally up to 30 years in length with an option to refinance should rates fall.

With interest rates dropping, this should free up further capital for the US consumer.

US housing market

Equally, the US housing market has been relatively strong recently.

US homebuilding rebounded in October with building permits reaching their highest level in over 12 years.

When housing transactions pick up, the impact is felt across the wider economy.

While, on balance, this argues against a recession in the short-term, monetary policy, alone, seems to be delivering diminishing impact.

While the recent pivot on interest rate policy should provide some stimulus to economic growth, it is clear that we are reaching the end of monetary policy’s potential.

Quantitative easing in Europe threatens fundamentally to weaken the banking sector, reducing its profitability and curtailing its ability to lend.

There is also the concern that it supports ‘zombie’ companies - those that would fail in normal economic conditions, but are kept alive by cheap debt.

This is bad news for the long-term productive health of capitalism.

Equally, businesses remain reluctant to invest.

In some industries it has fallen to zero.

This is unlikely to pick up until there is a clearer picture on various geopolitical tensions, which looks some way off.

Business investment in the US declined by 0.8 per cent year-on-year in the third quarter, the steepest decline since the fourth quarter of 2015. Ultimately, the weakness in manufacturing will likely be felt elsewhere in the economy as companies are forced to lay off staff.

Inflation

We would also add in inflation as another concern.

Investors have dismissed inflation as a significant worry in recent years and rightly so.

It has never emerged with any real bite since the global financial crisis. However, rising food and energy prices should not be dismissed.

Our conclusion? It is tempting to follow the broadly held consensus view that the outlook is soggy.

Investors need to look for opportunity to make gains even when the economic picture is mixed.

It is imperative to look through short term softening in data and remind ourselves that there are elements that could sustain growth for some time yet, albeit at the sluggish post financial crisis levels that we have become accustomed to.

Low growth appears likely, but recession is not a given in the short term and as a result there should be reasonable opportunities to make money for investors from here for diversified and risk aware processes.

James Klempster is director of investment management at Momentum Global Investment Management