The recent price action in the financial markets has many wondering whether we are heading towards a recession. Below is a summary of the economic data and indicators that we are looking at, along with our current outlook.
Markets have swooned so far in 2016 and people are looking at the stock and bond markets for clues as to whether a recession is on the horizon. One indicator is the extremely low level of nominal interest rates (such as the ten year US Treasury bond which was only yielding 1.78% as of Tuesday). However, the US has had extremely low rates for several years now and have seen a strong, sustained economic expansion. We think that foreign factors, such as negative interest rate policies (NIRP) in Japan and Europe are contributing to falling US rates. Turmoil in China and other emerging markets are driving up the price of the US Dollar, which is likely pushing bonds prices up (and yields down). Another indicator is a flattening yield curve, which generally means future opportunities are declining relative to current opportunities. However, the yield curve is not flat or inverted, which has signaled past recessions. It should be noted that with short-term rates so low, it is unclear whether the yield curve would (or even could) ever invert. Some economists are looking at alternatives to the traditional Treasury yield curve, but there are drawbacks to those approaches too. Nonetheless, one of the best recession indicators is not yet flashing imminent danger. Lastly, credit spreads have widened a huge amount and many spreads are at levels that we rarely see outside of recessions. However, many parts of the market are bifurcated along sector (such as energy and materials companies) lines, so average spreads are not a particularly valuable piece of data. Furthermore, we believe that the decreasing liquidity in the fixed-income markets (which we have talked about for several years now) is partly to blame. In summary, the market-based recession indicators are worrisome, because nobody is smarter than the market. On the other hand, we think that there are reasonable explanations for the price action.
Beyond the market, economic data is not yet pointing to a slowdown. Employment data continues to strengthen, wages and income are posting strong numbers, retail sales has not yet weakened, and industrial production remains relatively stable. We have seen quite a slowdown in durable goods sales and manufacturing, although this weakness is largely being attributed to declines in energy prices which should have positive impacts elsewhere in the economy. Some manufacturing data came in better than expected this morning, although it was still weak. Of course, weakness in any one area of the economy can spread, so we are monitoring the data closely. Economic data is mostly lagged and thus backward looking and the various data points do not always corroborate (much less perfectly), but the overall economic data does not appear dire to us.
Taking a step back, it is important to remember that economic growth and stock market performance is very loosely correlated. The markets can experience bear markets outside of recessions and stocks have often already bottomed by the time that a recession has been confirmed. However, some of the biggest bear markets have occurred during recessions, so the economy does bear watching. We have and continue to be cautious, but are also seeing more attractive valuations than we have seen in several years. At this point, we think that this represents more opportunity than risk.