One More Thought: Recession Risk
In our Annual Letter to investors we highlighted the collapse in the long-end curve as an indication of a maturing economic cycle (chart below):
Our friends at Variant Perception, recently shared a similar perspective:
A yield curve inversion has predicted every US recession since 1945, with only one false positive, in 1966 (although the false positive preceded a downturn in industrial production and a 25% decline in the DJIA). If you were a castaway on a desert island and you could only take one economic indicator with you, then you would take the yield curve. Last year, not one major economy’s yield curve steepened, and the pattern is continuing into this year.
Almost all major yield curves have flattened over the last 50 weeks. This is despite many central banks cutting or being in easing mode to try to combat falling inflation. When longer-term yields are falling relative to shorter-term yields, it is normally a signal that the economy as a whole wants to borrow less, and that the economy is slowing. Yield curves today are telling us global growth will slow in 2015. There is only a small recession risk at the moment, but continued flattening of yield curves would be a warning sign that things are due to get worse.
In addition to collapsing yield curves, global earnings momentum has slumped in recent months. While the energy sector has been a key source of these downgrades, revisions in US forecasts last month were the worst since the 2009 financial crisis. As illustrated below, the six month decline in forward earnings estimates is normally associated with a recession.
A few last points to ponder compliments of Andrew Lapthorne at Societe Generale:
It is fair to say that the consensus does not expect a US recession any time soon. As such the recent drop in consensus earnings expectations is being dismissed by many as attributable to weak energy prices and the translation effects of a stronger US dollar – two factors that will ultimately lead to cheaper prices in the US and a greater disposable income for consumers worldwide.
That may indeed be the case, but the counter-evidence is certainly mounting up. For one, if global economic acceleration was on the cards, why have 20 central banks cut interest rates already in 2015? Why have the economic surprise indicators fallen away, and why are most other countries also seeing major earnings downgrades – surely they should benefit from higher US dollar translation effects?