Who’s the Better Economic Forecaster – Me Or the Yield Curve?
I’ve been arguing that investors should overweight stocks over bonds, in large part because I don’t forecast a near-term recession. To say the least, things have not exactly played out like I expected over the past two months. Recession talk is all the rage, and of course the stock market has sucked.
Time to revisit the analysis. Could I be wrong? I know that sounds crazy, but the possibility must be considered. I’ll review my recession forecasting tool and compare it to the shape of the yield curve, another popular forecasting tool. The yield curve, for those of you with social lives, compares the yield on a long-term bond (say the 10-year Treasury bond) to the yield on a short-term one (the 1-year Treasury). A flat yield curve is when the yields are the same; an inverted curve is when the long bond has a lower yield. Lesson over.
In This Corner, Private Sector Debt...
Private sector debt is the sum of consumer and business debt. With that in mind, check out this picture:
Sources: Federal Reserve, Bureau of Labor Statistics, National Bureau of Economic Research
The historic cycle seems pretty clear. Lenders increasingly grow their loan books into a bubble, which then bursts, leading to credit tightening and a recession. But lenders uncharacteristically haven’t created a bubble over the past decade, obviating the need for a credit tightening. Hence my no-recession argument.
And in This Corner, the Yield Curve…
Now check out this picture:
Sources: Federal Reserve, National Bureau of Economic Research
A flat or inverted yield curve also reliably predicts recessions. Why? Because Federal Reserve responds to frothy private sector lending by raising its fed funds rate, with a lag. By then, investors have already noticed that lenders have begun tightening credit and that an economic slowdown is imminent. They therefore drive long-term bond yields down, anticipating that the Fed will have to reverse course and start easing. Higher fed funds and lower bond yields flattens/inverts the curve.
Why Doesn’t A = B?
Logic says that if A = C and B = C, then A = B. Therefore, if A (private sector debt) predicts C (recessions) and B (the yield curve) predicts C (recessions), then they should give the same signals at the same time. Yet the first chart above says that at present the private sector debt tool is not giving a recession signal, but the yield curve tool is. Now what? I’m going to give arguments that both could be giving incomplete signals, and then try to sort things out at the end. Don’t worry, it’s not complicated. I’ll leave you plenty of time for Netflix.
The Private Sector Debt Problem – It’s Not Us, It’s Them.
This picture compares private sector debt as a percent of GDP in the “advanced” economies with the “emerging” economies:
Source: Bank for International Settlements
The chart shows that banks in the advanced economies, led by the U.S., already carried into the 21st century a boatload of private sector debt. They had one more surge into the ’08 financial crisis, but since then have been responsible. But the emerging economies, led by China, have grown their private debt like crazy this century-to-date; on average by 14% a year. And the latest growth rate – early 2018 – was 18%!
China, and probably several other emerging economies in Asia and elsewhere, are set up for a major credit tightening and a recession. Since these economies represent a far greater share of the global economy than they used to, their credit tightening will slow the U.S. economy. And it certainly will hurt business earnings, especially for more global businesses. So that’s where my recession tool is incomplete; it’s U.S.-centric.
The Yield Curve Problem – The New Central Bank Business Model
Central banks – the Federal Reserve, the ECB and the Bank of Japan – were set up to smooth out economies; lower their highs and raise their lows. But the massive global growth in debt burdens has changed the central banks’ behavior. Now they act as if a key component of their job is to help manage their countries’ debt costs. To do so, the central banks have been setting unusually low fed funds rates and have bought substantial amounts of bonds (quantitative easing, or QE). For example, check out US fed funds rates and Japan/Europe/U.S. central bank QE:
Sources: Federal Reserve, Burau of Labor Statistics, St. Louis Federal Reserve (FRED)
Despite evidence to the contrary (Bitcoin), not all investors are idiots. They know that at the first hint of economic weakness, the Federal Reserve will start lowering the fed funds rate, back to 0% if necessary. And they know that QE, which is in reversal in the U.S. and is being halted in Europe (it will never end in Japan!), could easily be reinstated. As a result, I believe that going forward flat yield curves will occur more often and in response to less economic risk.
It really is different this time. The U.S. is now more vulnerable to outside economic forces than it used to be. And interest rates will tend to be a lot lower than they used to be. What’s an investor to do? My views are:
- I still hate bonds. A 2.9% return on a 10-year Treasury bond stinks; it remains barely above the inflation rate. Not nearly enough return for the assumed risks (inflation, etc.) over a decade.
- Cash is looking a lot sweeter. American Express, Goldman Sachs, Capital One and others are offering 2%+ interest rates. Yes, that is below the inflation rate, so you are still losing purchasing power, but compared to bonds…
- I still have to stick with stocks, but not just any stocks. Skip the bubble stocks like Wayfair and Tesla. Skip companies whose earnings are heavily tied to China and other emerging economies. Overweight well-priced domestic stocks.
Dare I recommend again my favorites, the private mortgage insurers? My beloved MGIC (symbol MTG) is selling at a laughably cheap 16% earnings yield (the average U.S. stock is under 7%) and Radian (RDN) at an even sillier 17%. Maybe some of the housing conversation is changing; shockingly, this weekend brought a CNBC story that “If history is any guide, the housing market could be the unlikely safe haven in the next recession once again.”