Interest Rates as an Economic Indicator

In December, we wrote about the yield curve and tariffs, and today the same topics are still in the financial headlines. At that time, we showed a chart of the yield curve and how it was ever so slightly inverted. Since then it has changed significantly, and we now have more evidence that the global economy could be on the verge of a recession. This update is going to have a lot of charts, so let’s get right to it.

When we last wrote about interest rates, there was only the very slightest portion of the yield curve that was inverted (downward sloping in the chart below), but now it is inverted all the way out to five years and the 10-year yield is below the short end of the curve.

Downward-sloping (inverted) yield curve implies economic slowdown

To give some perspective about why this is important, we can look at the historical data of the 10-year yield minus the 3-month yield. As of August 14, 2019, that value is about -0.4%, and over the past several decades, this has only happened just prior to recessions (shared areas indicate U.S. recessions).

This doesn’t mean we are going into a recession right away, or that the stock market is going down, but it is a reliable indicator that implies the odds of a recession in the next year are higher than they have been since 2007.

The FED is Cutting Rates

Along with the yield curve inversion, the Federal Reserve has begun to lower short term interest rates. This is more a result of the yield curve inversion rather than a cause. The Federal Reserve is aware of what’s going on in the economy just like the bond markets are, and the FED is doing what they can to mitigate the risk of a recession by lowering short-term interest rates. This will flatten out the yield curve and ease lending conditions for borrowers. At this point, the FED is just reacting to markets and economic data and trying to keep the economy growing. Looking at historical data, we can see that this lowering of rates is also correlated with recessions, so while the lowering of rates isn’t a cause of recessions, it does generally happen at the same time as U.S. recessions.

The Effective Federal Funds Rate since 1954

In fact, ignoring small moves, we count 12 larger moves down in the Effective Federal Funds Rate in the chart above and nine of them line up with recessions. We can’t yet call the current single rate cut a larger move yet, but one to two more are expected this year and if they go much beyond that, then we are likely in or headed into a recession.

In the last two easing cycles, i.e., when the Fed Funds rate is going down, the first cut preceded the U.S. recession by about 3 months. If the timing of this cycle is the same then either the fourth quarter of 2019 or the first quarter of 2020 will be the beginning of the next recession. There’s no certainty to the timing of this or that it will even happen in the near term, but that is how things progressed in 2000 and 2007.

Global Manufacturing Sector in Recession

We also see trouble in the manufacturing sector of the global economy. The Purchasing Managers’ Index (PMI) measures the growth of the manufacturing sector in many countries. A value above 50 implies growth and a value below 50 implies contraction. The average value for the seven largest economies is now below 50. Five of the seven largest countries are reporting contraction in manufacturing with Germany the lowest. Most of the countries are still near 50, which implies the level of contraction is currently still small.

Current Manufacturing Index Level for Largest 7 Economies

These have dropped below 50 recently in part because of the uncertainty around U.S. trade policy and the on-again, off-again tariffs the Trump Administration continues to toss around somewhat haphazardly. Businesses don’t like uncertainty and that has continued to hurt rather help the U.S. (and global) economy.

Stock Market Valuations Very High

Next, we want to look at stock valuations. Currently, stocks are at some of the highest valuations ever relative to earnings, sales, GDP and cash flow. This means that current prices are significantly overvalued relative to historical norms. Of course, they can always get more overvalued.

Historical percentiles were similarly high in 1998 and it was two years before the top of the tech bubble in 2000. That period was an anomaly when looking back pre-1998, but those 1998 levels are just on the high end of the range of valuations since 1998, so it’s certainly a possibility that we will see something similar going forward. Even so, we can expect lower returns over the coming decade versus the last decade because the last 10 years had valuations go from low to very high and while we can go higher, it won’t be sustainable and the next recession will bring stock prices back down.

Keeping the Long Term in Perspective

There are some bright spots in today’s economy as well. In July, Retail Sales, Building Permits, the Service Sector (non-manufacturing) growth and the Jobs Report were all positive. Also, second quarter GDP for the U.S. was 2% and the current forecast for the third quarter is currently around 2%. We could pull through this rough patch and continue the economic growth we’ve had since 2009. While the likelihood of a recession in the next twelve months is higher than it’s been since 2009, that does mean it will happen. More importantly, the long-term outlook (10+ years) is great with new technology and innovations that will drive the global economy forward. Even if we do struggle in the next few years, the long-term future is very bright.

Finally, what do we do about all of this? For current clients, we are well positioned already and have become more defensive recently due to the current environment. At this point, we can wait to see how things develop. If we end up with significantly lower prices for stocks and lots of fear in the markets, we will be ready to get more aggressive by buying equities at lower prices. For those of you not currently clients, if all of this is making you worried you aren’t prepared or are taking too much risk with your investments, we’d love to talk with you about your situation!

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Jason Draut, CFP®
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Chris Sheehy, CFP®
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Santa Cruz, CA 95062
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