MUNSBACH
YVES LONGCHAMP

The U.S. economy is believed to be in a late business cycle and, as all cycles end in a recession, the obvious question is when we can expect the next one. The last 10 U.S. recessions have been preceded by a yield curve inversion engineered by multiple Fed rate hikes. Therefore, the current flattening of the curve in the wake of the hiking cycle raises the spectre of the next recession. According to Bloomberg, “Some Fed regional bank presidents want the central bank to be cautious in raising interest rates to prevent short-term Treasury yields from rising above long-term ones […]. Those policy makers argue that such a yield-curve inversion has proven to be a reliable harbinger of past recessions.”

For the last 70 years, each recession was “announced” by an inverted yield curve, making the slope of the curve (often estimated as the difference between the 10-year and the 2-year Treasury yields) a reliable and timely indicator. In the U.S., it is still upward sloping, as the difference between the 10-year (3%) and the 2-year yields (2.7%) is positive (30bps). Yet, according to Fed forward guidance, interest rates are set to rise by 25bps a quarter for at least 12 months. This suggests a yield curve inversion may happen this year and makes the prospect of a recession in 2019 likely.

Yet, while the yield curve is undoubtedly a key indicator for recession, it is important to note that not all inversions lead to recessions. So as the yield curve can provide a false signal, it needs to be used in conjunction with other indicators to improve accuracy.

One of these is the S&P 500’s performance. For the last 10 recessions, this benchmark equity index declined by about 5% on average in the year prior to the recession. A return of more than 13% in the last 12 months suggests the likelihood of a recession in the next year is quite low.

Other key indicators are the unemployment rate and manufacturing production. On average, the first hits a low and the second a peak around 8 to 9 months prior to a recession. As current data here also does not indicate a need for concern, what does that say about the likelihood of a recession?

Timing a recession is difficult, if not impossible, as no set of indicators provides a completely reliable advance signal. Although none of our selected indicators are currently in recession mode, based on recent developments their prospects have deteriorated. The U.S. yield curve has flattened and may invert this year. The unemployment rate, which has been hovering around 4% for the last nine months, is low by historical standards. Manufacturing production has done well but its outlook is impacted by the rise of international trade tariffs, and the S&P 500’s six-month performance was negative.

All in all, we believe that the likelihood of a recession in the coming 12 months is low. However, as Fed interest-hiking cycles always end in a recession, we encourage investors to monitor developments in the U.S. economy carefully. Early signs of growth weakness there will provide investors with valuable hints, in particular those invested in equities.

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