Do Inverted Yield Curves Predict Recessions?

From August 24th, 2018…

Markets

• Dow Jones Industrial Average 25,790.35 – Up 4.3% Year to Date

• S&P 500 2,874.69 – Up 7.5% Year to Date (A new Closing High)

• S&P 400 Mid-cap 2035.10 – Up 7.1% Year to Date

• S&P 600 Small Cap 1091.55 – Up 16.6% Year to Date

Federal Reserve

• Federal Reserve Chairman Jerome Powell noted today

  • Inflation is at the Fed’s 2% target

  • No signs that it will continue to accelerate

  • Market/Economy not likely to overheat based on current conditions

• Interest Rates

  • Already had 2 interest rate increases this year ¼ point each time

  • 2 more rate increases expected before the end of the year

• Employment

  • US Unemployment rate at 3.9% which is close to an 18-year low

  • Minutes from last Federal Open Market Committee showed officials believe wages are poised to rise

Trade Wars

• New 25% tariffs added last night (Thursday at Midnight) on $16 billion of Chinese goods

• China responded with new tariffs of equal value on US products

• Latest rounds of talks ended this week with no agreement

  • President Trump noted no breakthrough expected as the talks were between lower level officials then past discussions

• Chinese yuan has fallen sharply against the dollar during this period

• China’s main stock market, the Shanghai Composite is currently in a bear market as a direct result of the trade war

• While US stocks are currently hitting new highs, we do not anticipate this can go on permanently with an ongoing trade war

  • However, as we discussed in the early spring, the US economy is more balanced and less dependent on exports and thus better positioned for a protracted trade war

Nine Years of US Economic Expansion is now the second longest in history

• To become the longest expansion needs to last through June 2019

• Longest period was March 1991 to March 2001

4% GDP Growth

• U.S. Economy grew by 4.1% in the 2nd Quarter 2018

  • The fastest economic expansion in 4 years

• Atlanta Fed predicts 5% growth in the 3rd Quarter of 2018

  • Congressional Budget Office is less optimistic and project 3.1% for Q3 2018

• Since 1947 Quarterly GDP growth of 4% or higher has occurred 105 times

  • Only 27 of those since 1990

First, with ongoing interest rate increases I would not look at or consider short term bonds at all. The short end of the yield curve is where the Federal Reserve has the most control, and they have signaled that rate increase will continue. Specifically, with 2 more projected for this year.

While, an inverted yield curve has been an indicator in the past of increased volatility, increased volatility is not necessarily linked to market declines. Looking at the current market the fundamental factors that seem to be supporting the rally over the last 18 months seem to be more in line with policy decisions out of Washington including a lower tax environment for both corporations and individuals along with a significant reduction in regulations.

I am under the belief that those have not been fully realized by business and should

continue to provide growth in profits going forward. On the subject of Washington policy, we cannot ignore the ongoing discussions of a trade war.

The renegotiation of NAFTA with Mexico was a significant step in improving US trade agreements. We have seen much of the commentary on this agreement focused on where this deal leaves Canada (I believe Canada will come around and agree to join the US/Mexico deal or sign their own bilateral agreement shortly) but what the commentary

has missed or failed to discuss in significant detail is the requirement for higher US or

Mexican made components in cars that enter the US from Mexico duty free. This step while benefiting US and Mexican workers is a sizable setback for China. China was dealing with a slowing economy before the tariffs started and has only seen slowdown continue as the tariffs continue. As the pressure directly from the US and indirectly from bilateral agreements with other countries, our belief is China will be forced to make concessions in their US trade agreement.