Is the US heading for recession in 2020?
The ongoing trade wars and some recent weak data from the manufacturing sector have raised questions over a slowdown in the US economy. We look at the bond and labour markets to see what they are telling us about the potential for a recession in the US in 2020.
Government bonds suggest imminent recession
The bond market has a good track record of predicting recession for the US economy. With one exception, in 1966, every time the US yield curve has inverted, the US has entered recession within 18 months.
The yield curve is the line that traces the level of interest rates for bonds (debt issued by a country) of different maturities. Typically it should cost less to borrow money for shorter than for longer periods of time. A yield curve for a normal functioning economy should therefore slope upwards, with longer dated bonds having higher rates of interest than shorter term bonds.
Here, an inverted yield curve is defined by the US 10-year bond yield being lower than the three-month Treasury bill rate at month-end. The most recent such yield curve inversion was in May this year, suggesting that the US economy may be destined for an imminent recession.
The US yield curve is predicting recession
One of Schroders’ own recession models puts the probability of recession within the next 12 months at around 40%. With one exception (1966), every time the recession probability has risen above the critical level of 25%, a recession has followed.
Our model suggests c.40% chance of US recession
Source: Refinitiv DataStream, Schroders, 4 October 2019
Corporate bonds signal no recession
It’s not all doom and gloom. The New York Federal Reserve has several models to forecast a US recession, one of which places the probability of recession at a far lower level. This is the excess bond premium (EBP) model, which is designed to gauge investor sentiment in the corporate bond market. The current probability of recession according to this indicator is 10%.
Excess bond premium model sees 10% probability of recession
Labour market robust, for now
The jobs market remains an area of strength in the US. Workers in the US have begun to work fewer hours but earnings growth remains healthy. Such conditions should support further growth in economic activity going into 2020.
However, momentum in the jobs market appears to be losing steam, as the rate of jobs growth slows. If this continues, a period of economic slowdown (or outright recession) is likely to come sooner rather than later.
Forward-looking indicators in the jobs market also highlight the need for caution. The US Conference Board’s Employment Trends Indicator (ETI) has stabilised, potentially reaching a turning point. This could mean a recession will follow or it could mean that, as in 2014/15, the economic expansion will continue.
Is the Employment Trends Indicator at a turning point?
How can investors respond?
Although there are some signs that growth is slowing, a recession is not necessarily on the way. There is support from central banks with interest rates near zero for most major economies. Even so, investors may want to consider how sensitive their stock market investments are to the economic cycle. Periods of slowdown and recession are the phases of the business cycle when shares perform most poorly.
What is more, Schroders is forecasting a profits recession for US companies, with profit margins being squeezed by wage growth and slowing demand. If the economic slowdown gathers pace, companies are likely to reduce capital spending and headcount. In this scenario, investors may want to exercise caution when it comes to lofty stock market valuations.
US economic profits – actual and forecast
Bond market prices are also at relatively expensive levels. These could soon start to unwind, even though bonds tend to perform better than equities during a recession. The yield curve tends to turn from inversion toward a more normal upward sloping shape quite quickly (meaning long-dated yields rising and/or shorter dated yields falling. Remember, yields move inversely to prices).
Historically, the average length of US curve inversions averages around nine months, suggesting that the yield curve could be positively sloped by around end-Q1 2020.
Combining the outlook from the labour and bond markets, it appears that a continued slowdown in the US economy is inevitable, but that does not necessarily need to lead to a recession, especially if policy support provides a foundation for activity. Certainly policy support, whether from central banks or governments, would likely help asset market valuations remain at relatively high levels.
The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.