Podcast: The Recipe for Recession Isn’t What You Think
The Investment Conversation: The Recipe for Recession Isn’t What You Think
VO: Welcome to The Investment Conversation, Lord Abbett’s ongoing podcast series.
Will Andrews: This broadcast was originally recorded on September 4, 2019.
Andrews: The recent inversion of the U.S. Treasury curve has sparked concern that the U.S. economy will slip into recession after a decade-long expansion. But it seems that the recipe for recession isn't as simple as a change in the relationship of short- and long-term interest rates. There are a number of factors that can combine to tip an economy into negative growth. Some of them can be tracked over time, while others are far more difficult to predict. So, what does this all mean right now for the U.S. economy? We'll discuss that and more in this edition of The Investment Conversation.
Hi, I'm Will Andrews and joining me today is Lord Abbett's director of strategic asset allocation, Giulio Martini. Welcome, Giulio.
Giulio Martini: Thanks, Will. It's a pleasure to be here. Thanks for inviting me.
Andrews: So, Giulio, is an inverted yield curve necessarily a one-way ticket to recession?
Martini: Well, the brief answer is no, it isn't. But let's just back up a little bit and think about what the yield curve is. [It’s] a description or a chart of interest rates at different maturities. And when the yield curve is inverted, it means that longer-term interest rates are below shorter-term interest rates.
Now, you can think of interest rates at different maturities as being related to each other. To a first approximation, a longer-maturity instrument is just a series of rolls of a shorter-maturity instrument. So, if you take a three-year [U.S.] Treasury note, for instance, you can think of that as just 12 rolls of a three-month T-bill [U.S. Treasury bill].
So, if the three-year rate is below the three-month rate, it means that investors are expecting short-term interest rates to fall and, therefore, long-term interest rates to be below the current short-term rate. Now, the reason why an inverted yield curve is taken as a negative indicator by investors is that the yield curve has in fact inverted before every U.S. recession in the post-World War II period. And that's a pretty regular pattern, so people start to get worried when they see long-term interest rates falling below short-term interest rates, because of that relationship that has held, historically.
Andrews: Does an inverted curve always precede recession? Has it always been a reliable signal?
Martini: No, it hasn't been. The yield curve has inverted without a recession following in the next one to two years a number of times. It did so twice in the 1990s; once in 1995 and then again in 1998. And prior to that, also, in the late 1960s. But I think the key point is that there's nothing that relates the inversion of the yield curve, causally, to a downturn in the economy.
In other words, it's not as if the expectation that interest rates will fall triggers delays in capital spending or delays in consumer auto purchases or delays in inventory financing that bring about the downturn because people are waiting for lower interest rates to spend. Instead, the fact that interest rates are expected to decline is related to the fact that the economy slows down before every recession.
We never go from boom or above-trend growth directly into a recession. The economy transitions through a slowdown before a recession follows. And it's during those slowdowns that investors start to expect short-term interest rates to fall. So, the reason you see this relationship between the yield curve and recession isn't because the yield curve causes the recession.
It's because the yield curve is responding to an economic slowdown, and the economy always slows before a recession takes place. Now, that's important right now because we just had a quarter where GDP growth was 2% in the second quarter of 2019. The current estimates [from the U.S. Federal Reserve Bank of Atlanta] are that, in the third quarter, GDP growth is going to be about between 2% and 2.5%. And those are both growth rates that are above most estimates of potential output growth right now.
So, the economy's actually growing above trend. The slowdown that would lead to the recession has not even begun yet. And so, this is a contender for another case where the yield curve inverts without a recession following in the next year or two.
Andrews: Apart from the inverted curve, recession worriers point to the current U.S.-China trade conflict. Can you give us your view of the near-term impact, and what could happen if it drags on? What are some of the dynamics here that we should be thinking about?
Martini: Well, there are a couple of things to unpack there. So, first of all, let's just think about the direct impact of trade friction between the U.S. and China. That direct impact is actually likely to be pretty limited. The reason [is] that when you look at Chinese exports to the U.S., they're only 3.6% of GDP. So, even if we had a 10% drop in Chinese exports to the United States, that would have a direct impact of 0.3% to 0.4% on Chinese GDP. That's not that large. And if you turn that around, U.S. exports to China are less than 1% of U.S. GDP. So, even if U.S. exports to China were to go down by 10% or 20%, the effect on GDP would be kind of a rounding error. So, the direct impact isn't that large.
The second layer, though, is that the trade conflict between the U.S. and China is generating lots of uncertainty. In other words, it's possible that this trade conflict is just the first skirmish in what turns out to be a much broader strategic conflict.
And if that's true, then, the investments that U.S. companies and global multinationals have made in China are going to become much less valuable. And the investments that Chinese companies have made in the U.S. and around the world could also suffer. So, it's generating a lot of uncertainty that it's not clear what the scope of this conflict really is and how it's going to affect the global economy and the location of global assets and global productive capacity.
The other aspect to keep in mind is that we don't have a lot of historical examples of trade conflict to rely on in trying to understand how this may play out. The last really global trade conflict was in the 1930s and it was one of the elements that led to the Great Depression and -- very poor global economic performance during that period.
But in the last 80 years, we don't have anything to fall back on to try and understand how this may unfold. And of course, investors and markets hate uncertainty. Risk is an everyday thing, when you can look at probability distributions. But you need a lot of cases and a lot of examples to understand risk in that sense.
It's in nobody's interest to have a full-blown trade war. It's going to potentially damage President Trump's reelection chances if this intensifies and creates enough uncertainty to really have a very negative impact on the [U.S.] economy. And it's also going to do damage to Xi Jinping's power in China, if the Chinese economy starts to really falter badly because of an inability to really negotiate an outcome that's more benign.
So, it's in the interests of both sides to resolve this and we could have a very good outcome, too. But we could also have something that's worse than what we've seen so far. And that's why markets are just undecided about which way to go with this.
Andrews: As a reminder, visitors to our podcast page on lordabbet.com can view a terrific and timely display that Giulio put together on the U.S./China trade dynamic. But let’s shift gears a bit. You’ve told us that following World War II, U.S. recessions had some common ingredients, but that the recipe has changed in the past few decades. How so?
Martini: Well, recessions used to be pretty simple affairs. From the end of World War II until the end of the 1970s, recessions were always following the same script. The economy would be in a period of economic growth. Eventually, economic growth would unfold for long enough to start to trigger inflation pressure.
Inflation pressure would cause the Fed [U.S. Federal Reserve] to start raising interest rates. Once interest rates went above regulated ceilings in the banking system, the banking system would disintermediate. The housing sector would be denied funds absolutely. And very interest-rate-sensitive sectors of the economy would drop extremely sharply and that would trigger the downturn.
Since we had broad-based financial deregulation, the recessions that have followed have been much more complicated. And they've been the outcome of multiple causes, so that in the early 1990s, the recession that we had was caused by mild corporate deleveraging and an energy price shock that hurt consumer spending as a result of the U.S. invasion of Iraq in response to Iraq's invasion of Kuwait.
At the end of the 2000s, we had another recession that was triggered by the bursting of the tech bubble and the stock market, tremendous negative wealth effects, and also an oil price shock. And then in 2008–2009, we had a very serious recession that was created by first, really a very significant pullback in activity in the housing sector, a liquidity crisis that was created by the failure of Lehman Brothers, and an oil price shock, again.
So, the modern recessions have really had multiple causes. It hasn't been just [that] inflation gets too high [and] the Fed tightens; we have a recession to bring inflation back under control. It's really been multiple things converging to create the downturn.
And as I said before, the road is always from strong growth to weak growth. And during that period of weak growth, you get a shock that leads to a recession. And every one of our recessions has had an oil price shock as part of the story. And that's an element that could be very different this time around.
Andrews: Well, that’s interesting, because we’ve recently seen the U.S. expansion set a record for longevity. Can you give us your assessment of where things stand now, and the likelihood that the expansion will continue? It almost seems hard to believe that the economy is still in a position to continue growing after 10-plus years.
Martini: It's 122 months and counting. We're in month number 123 right now. And it doesn't look like there's going to be a recession, certainly, in 2019. And I don't think we're going to have one in 2020. So, this is going to continue adding to that record. And the reason I feel fairly confident about economic growth in the future is that inflation remains very, very low in the U.S. economy.
And so, I think the Fed will be able to continue to execute a pretty accommodative monetary policy, which [should] support economic growth. And I also don't see some of the triggers which could really lead to a downturn as really being in a position where that could happen in the short run.
So,housing activity is not elevated or exaggerated right now. In fact, spending on residential construction in the U.S. economy is closer to what it has been at past troughs or bottoms in economic activity than it [was] at prior peaks. Capital spending has become much less cyclical because so much more of what U.S. corporations spend on is intellectual property, software, copyrights, rather than the kind of highly cyclical equipment and construction spending which dominated in the past.
The same [holds true] for autos. Autos and consumer durables are another highly cyclical item. But what we see is households that are in great shape right now. We have almost record high household real net worth, a savings rate that's just under 8%, which is very high for the U.S. economy; and also, we have falling energy prices.
So, you've got consumer spending that's not only been very strong in the second quarter of this year and into the third quarter, but the underlying fundamentals to sustain it going forward remain quite strong. You just don't have in place any of the triggers which have led to downturns in the past. Instead, what you see policymakers and investors worrying about is this idea that the [U.S.-China] trade conflict and unpredictable policymaking is going to cause a loss of confidence that's so large that we're going to talk ourselves into a downturn, rather than have some objective [factor like a] loss of spending trigger a downturn.
That has never happened before that the world has talked itself into a downturn by inducing paralysis through some loss of confidence. And honestly, the data just don't support that interpretation right now. I just can't buy that kind of story about weakness developing to such an extent that GDP actually falls in the United States and goes way below in the trend in the world as a whole. That story does not resonate for me.
Andrews: But Giulio, an extended U.S.-China trade war that sours the mood of the U.S. consumer could call all those assumptions into question.
Martini: So, I could see all those factors leading up to a slowdown in GDP where growth goes from above trend to below trend. And a slowdown in GDP is the precursor to a possible recession. But a slowdown in and of itself doesn't lead to recession. You need some kind of shock to take a slowdown and turn it into a downturn.
And that's a shock that historically (as I mentioned), the last six recessions have had a spike in oil prices implicated as part of the shock that took a weak situation and turned it into consecutive quarters of negative growth; the classic definition of a recession.
And so, I think you are in a situation where concerns about global trade conflict, uncertainty about broader economic and strategic issues lead to some loss of confidence (which causes hesitation) that's significant enough to take GDP growth down to low enough rates that the economy's vulnerable to recession.
But then, you need something else that's going to produce that downturn. And instead, what we're seeing is, at the first sign of potential weakness, policymakers are rushing to put measures into effect that are going to sustain growth by cutting interest rates, foregoing planned interest rate increases; in Germany, [they are] talking about fiscal stimulus, which is a big thing.
And also in the United States, [there are] some rumblings about support on the fiscal side if growth really looks like it's going to weaken. So, that's the opposite of what's happened in the past when a vulnerable economy has met policy that continues to tighten, and we eventually get a downturn. When you have weak growth but the response to weak growth is to stimulate demand, we've never had a recession after that. We've always had, ultimately, a recovery.
Andrews: Okay, can we zero in on what this all means for investors? What should they be thinking about in the current environment? Would you say this is a “risk on,” or a “risk off,” situation?
Martini: Well, in the very recent past, we had global stock prices really peak—early in 2018—and not do much since then. And in the U.S., we also had a peak in early 2018; another one in September, 2018; and a slightly higher peak just late this past July .
But stocks haven't done a lot in the past few years. But bonds have done very well. We're pretty close to the lows for this cycle in the 10-year [U.S. Treasury] bond yield. And so, I think we've probably got a situation where investors, given this kind of uncertainty, have (more or less) been happy to ride the falling bond yields and just really enjoy the benefits, in terms of rising bond prices.
And I suspect that investors are probably a little bit overweight bonds, relative to stocks, compared to what their long-term allocation is, whether that's 60/40, 70/30, 50/50; whatever it is. And so, I think this is a great opportunity to rebalance portfolios and get back to those long-term allocations. I wouldn't make a case for either of the extremes.
In other words, I don't think we have to go to “risk off” where you really want to reduce your exposures—to stocks, to credit, to other assets which benefit from a good environment. And I also don't think that valuations are such that you really want to take a strong “risk on” stance. If you look at stocks globally, they're valued at about the long-term median of the past 25–30, years right now compared to current earnings expectations.
You look at spreads and corporate credit, or in high yield, and they're pretty close to long-term averages. So, they're not saying this is a great time to jump in. So, I think what you want to do is take this opportunity to really look at your asset allocation, remember why your asset allocation is what it is, see where your current portfolio is compared to that, and rebalance.
And I suspect what that means, in many cases, is reducing your bond exposure to get back up to target in your stock exposure. And I think that would be a healthy thing to do right now, after a really good run in the bond market.
Andrews: Well,Giulio, this has been a terrific discussion. Thanks as always for your insights and thank you for joining us today.
Martini: It's my pleasure to have been here, Will, and look forward to doing this again sometime in the future.
Andrews: Well, to sum things up: While the markets and financial media focus on an inverted U.S. yield curve as a harbinger of recession, in reality, there are a number of other conditions necessary to bring on a downturn. In the absence of a major shock such as a severe spike in oil prices, the evidence still suggests that the U.S. expansion will remain on track. With that in mind, and in the context of recent equity and fixed-income valuations, we think investors should avoid making drastic and sudden changes to their current allocations. Instead, we believe they should make sure that their current exposures remain in line with their long-term investment goals.
VO: That’s it for this edition of the Investment Conversation. Please drop us a line on social media or visit our website at LordAbbett.com. Our audio podcasts are available on iTunes, Spotify, TuneIn, and other major streaming media services. Thanks for listening.
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