Should I worry about recession?

We recently run into an article on yahoo finance with title: 

A recession indicator that predicted every downturn since 1969 started flashing months ago—and a Wall Street veteran warns it always works on a delay

You can read the original article. But before we get into the economic logic, what do you think about recession? Are you really concerned about U.S. entering a recession? 

 Introduction

In the world of finance and economics, the word “recession” can instill fear and uncertainty among investors and the general public alike. The possibility of an economic downturn can have far-reaching consequences, affecting everything from job security to the performance of the stock market. It’s no wonder that Wall Street analysts and investment strategists closely monitor various indicators to gauge the likelihood of a recession. One such indicator that has gained significant attention is the yield curve.

Understanding the Yield Curve

The yield curve is a graphical representation of the relationship between the yields of different bonds, typically the U.S. 10-year Treasury and two-year Treasury bonds. Normally, the yield curve slopes upward, indicating that longer-term bonds have higher yields compared to shorter-term bonds. This makes sense because investors demand higher returns for locking up their money for longer periods. However, there are instances when the yield curve inverts, meaning that long-term bond yields drop below short-term bond yields.

The Significance of Yield Curve Inversions

Historically, every U.S. recession since 1969 has been preceded by a yield curve inversion. This powerful indicator has been a reliable tool for predicting economic downturns. When the yield curve inverts, it suggests that investors are becoming increasingly pessimistic about the economy’s prospects. They start moving their money away from short-term bonds and into long-term bonds, anticipating a decline in economic activity that would force the Federal Reserve to cut interest rates.

The Delayed Impact of Yield Curve Inversions

While yield curve inversions have consistently preceded recessions, not every inversion has resulted in an economic downturn. In fact, there have been six yield curve inversions since 1969, including a brief inversion in March 2022 after Russia’s invasion of Ukraine. This inversion did not lead to a recession, highlighting the complexity of economic indicators and the need for cautious interpretation.

The Warning Sign for the Current Economy

Despite the uncertainties surrounding yield curve inversions, some experts believe that the current inversion should not be ignored. Megan Horneman, chief investment officer at Verdence Capital Advisors, points to the yield curve inversion and other economic signals as evidence of an unavoidable recession in the near future. She highlights the fact that, historically, it takes about 15 months for the economy to officially enter a recession after a yield curve inversion. Applying this timeframe to the current inversion, it suggests that a recession could occur as early as October of this year.

Additional Economic Signals

Apart from the yield curve inversion, there are other economic indicators that support the possibility of a recession. The Conference Board’s Leading Economic Index (LEI), which incorporates various data points such as building permits and manufacturers’ new orders, has been declining for 14 consecutive months. This index provides a snapshot of the overall health of the economy and its persistent downward trend raises concerns about future economic performance.

Furthermore, despite a slight decrease in year-over-year inflation, Federal Reserve Chairman Jerome Powell has expressed concerns about ongoing inflation pressures. He has emphasized the need to continue the fight against inflation, suggesting that further interest rate hikes may be on the horizon. History has shown that most tightening cycles by the Federal Reserve do not result in a soft landing. In fact, the majority of these cycles have led to economic recessions.

Implications for the Stock Market

Recessions are generally not favorable for the stock market. Economic downturns can slow down growth, increase unemployment, and negatively impact corporate earnings. Megan Horneman warns that the stock market rally witnessed in the first half of this year may not be sustainable. She argues that equity markets historically do not bottom out until a recession is imminent. In the past, after the yield curve reaches its lowest level, the S&P 500 has only posted an average gain of 4.4% in the following 12 months. However, the index has already seen a substantial increase of nearly 9% since the yield curve reached its lowest level in March.

Horneman predicts a potential decline of 10% to 15% in the stock market when investors become more realistic about the interest rate environment, economic conditions, and earnings outlook. This projection aligns with the notion that the first half stock market rally was an anomaly compared to historical trends.

Conclusion

While the yield curve inversion has proven to be a reliable predictor of recessions in the past, it is essential to approach economic indicators with caution. Not every inversion guarantees a recession, and there are other factors at play in the current economic landscape. However, the yield curve inversion, along with other economic signals, does raise concerns about the possibility of an upcoming recession. Investors should remain vigilant and consider these indicators when making financial decisions. It is always advisable to consult with a financial advisor to assess individual risks and develop an appropriate investment strategy.

Disclaimer: This article is for informational purposes only and should not be considered financial advice. The stock market and economic conditions are subject to change, and individual circumstances may vary. Consult with a qualified financial advisor before making any investment decisions.