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The R-Word - Should we be worried about a recession?

Yield curve inverted: what does it mean?

The drumbeat of recession got a little louder on August 14th and markets reflected as much with an 800 point decline, the 3rd largest point loss in the history of the S&P500. The yield curve inverted & volatility has continued to date.

That all sounds pretty dramatic, not to mention complicated. It makes people think of putting their hard-earned money under the mattress to wait out the coming storm.

However, before stuffing the Posturepedic, let’s have a look at some of the underlying detail regarding recent volatility in global equity markets. Oh, and while I’m at it, 800 may be the 3rd highest ever point loss on the Dow Jones, however it’s only the 82nd largest percentage loss, a fact lost on most ‘news’ channels. Just sayin’.

Inversion of the yield curve

What does it mean and why is it important?

The yield curve is a chart that plots bond yields of various durations. A 10 year bond pays more interest than a 2 year bond, a 20 pays more than a 10, 30 pays more than 20 and so forth. So when the economy is in good shape now and looks to be so in the future the line curves upward.

Economists pay particular attention to the yields on the 2 year and 10 year bond. Remember our chart? The 10 year bond should pay more that the 2 year bond, right? Well, not so fast. On August 14th the 2 year paid a hair more than the 10. Subtracting the 2 year yield from the 10 year produced a negative number.

This is an example of an inverted yield curve. The line on the chart has begun to curve downward.

Why is this important? Well, every time this has happened in the last 50 years it has been followed by a recession. The last time it happened was 2006.

This inversion was brief (and it’s been it’s been up & down since) managing to finish flat this past week (the yield on the 2 year and the 10 year are the same), however history is hard to ignore. The attached FRED chart shows 5 major recessions and the yield curve inversion that preceded them.

Recessions (technically 2 consecutive quarters of negative growth) typically arrive 6-18 months after inversion with the average being about a year.

We may play around the +/- line for some time and an inverted yield curve by itself is no guarantee of a recession. However, there are other signs (manufacturing orders, hiring intentions, Trump excoriating Fed Chairman Powell for not dropping rates quickly enough) that skies are starting to darken.

We’ve had an extended period of recovery and growth after a sharp and very deep recession in 2008/9. As things stand today economists see the possibility of a recession that’s shallower than most but also longer. In other words, there’s no need to panic. This is not 2008/9 again. This is just a normal part of the business cycle.

Oh, and just in case you’re thinking of stepping off the track and allowing the train to pass, the average rate of return in of the S&P500 in the 12 months following the last 8 inversions was in excess of 15%. It’s harder for firms to maintain or increase profit margins at this stage in the cycle, but not impossible.

Areas such as utilities, consumer staples & pharma have tended to outperform in recessionary times. It’s also worth mentioning that bonds with longer durations tend to benefit in falling interest rate environments, an environment we’re likely to encounter within the next 6-18 months according to the bond market.

Investors should have an investment strategy that best mirrors who they are as investors and what goal(s) they have for the future. Some goals are longer term than others. Longer term investors need not be concerned about short term changes in the business cycle however there are usually ways of reducing risk in a portfolio without changing the entire investment strategy.

There’s nothing cataclysmic on the horizon at the moment though there are always surprises. As difficult as it can be with all the noise and incendiary language out there, stick to your plan rain or shine

“If you don’t know where you are going, any road will get you there.”
– Lewis Carroll, Alice in Wonderland

Brendan O’Brien,
Proprietor, Hibernia Financial Group
Sr. Financial Advisor, Manulife Securities Incorporated

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