This month I’d like to present a letter from John Rovansek of Great-West Life:
Over the past few weeks, I sent out correspondence on a couple of themes. The first theme focused on building a case for considering, or re-considering, US investments and the second theme built a case for consideration in adding global fixed income exposure to client portfolios. Based on recent financial data, articles & interviews, I thought I would ponder the question – are we headed for another recession?
Since the end of May a number of headlines have made their way to the front pages of financial publications. One prominent headline on May 30 featured Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group. Mr. Mobius postulated that another financial crisis is inevitable because the causes of the previous one haven’t been resolved. His thesis focused on the derivatives market, and specifically, the effect the volume of derivative “bets”, in different directions, will have on volatility in the equity markets. He also cautioned that the largest US banks have grown larger since the financial crisis as has the number of “too big to fail”. If his prediction proves correct, the US taxpayer will once again be forced to protect those deemed “too big to fail”.
A second headline was the hawkish tone that Mark Carney, governor of the Bank of Canada, signaled when he delivered his May 31 speech to hold the line on interest rates. Mr. Carney pointed to continuing global threats & the dampening effect of the strong Canadian dollar on exports for keeping rates steady. He also indicated he is worried about a slowdown in spending by US consumers but also acknowledged inflation is hotter than was anticipated in Canada, and this could be interpreted as a sign the central bank will raise rates before the end of the year.
Do these headlines indicate we are headed for another global recession? I suggest we look to yield curves for guidance. Yield curves are leading indicators. Let’s examine the US yield curve to get sense if a return to recession is on the horizon in the US. Why? For several reasons. One, the US is the largest economy on the planet. Two, economic expansion has been increasing, albeit at a morbid pace. Three, the Federal Reserve has been steadfastly accommodating on its monetary policy.
With the Federal Reserve’s benchmark rate at zero to 0.25% & the 10-year Treasury note yielding approx. 3.06%, the spread between the two interest rates is among the widest in history. It’s when we see an inverted yield curve – short rates above long rates, that recession takes hold. The spread derives it predictive ability from the simple fact that one rate is artificially pegged by the central bank while the other is determined by the market. When the yield curve is steep, as it is now, it induces banks to expand their balance sheets – borrow short, lend long & increase the money supply. That US bank credit isn’t growing is more a reflection of the lessons learned during the period of excess leverage & in part to the new lending standards imposed by banks.
The time to worry about recession is when the Fed raises the funds rate to the point where the yield curve inverts. The yield curve is one of 10 components of the US Index of Leading Economic Indicators. Historically, the yield curve has been the first of the leading indicators to signal a turn in the business cycle. With the spread currently about 300 basis points & the Fed in no hurry to raise short-term rates, recession doesn’t appear to be on the horizon any time soon. In the recession that we just completed, the fed funds rate rose above the 10-year Treasury yield in June 2006. The US recession started on or about December 2007. Over the past seven expansions, they lasted, on average, 71 months. The current one is not quite 24 months old, and by some metrics, it has yet to get going. The US $15 trillion economy won’t, & doesn’t turn on a dime. While the possibility for a recession may still exits, the probability remains small. Things don’t change that quickly.
For the time being, being contrarian and looking at the aforementioned themes of US & global opportunities may prove to be correct after all.
If you would like to talk about John’s comments and how they might affect your investments, please give our office a call and make an appointment to speak with one of our financial advisors.