By Jim Ortlip & Fred Baerenz
With all the bad stock market news lately, many economists are trying to tie bad economic news in China, Europe and the Middle East into a US recession narrative. The most famous of the doomsayers is Dr. Nouriel Roubini, literally known as “Dr. Doom,” since he has predicted 10 of the last two recessions. While he correctly predicted the implications from the housing bubble of 2007, he generally finds bad news everywhere he looks.
While we are also concerned about the US annual debt and growing deficit, we still have lots of confidence in the US economy. Although we would have preferred more robust growth over the last decade (the first time in a century when the US economy did not exceed 3% growth from 2007-2015), we continue to struggle on in what Brian Wesbury refers to as “plow horse” economy, not a “racehorse” economy. Think of a horse slowly putting one foot in front of the other, without ever breaking out into a trot.
One of the best predictors of recession is when the “yield curve” is inverted. Think about this the next time you walk into your bank lobby, or check rates online. Everyone knows that 1 year Certificate of Deposits are supposed to pay less than 5 year CDs. That’s because of what we know as “illiquidity risk,” which is a fancy way of saying that one expects to be paid more if one commits money for a longer period of time. Similarly, 2 year treasuries are expected to pay less than 10 year treasuries. The difference between the interest rates paid on the different time frames is known as the “spread.” If one plotted interest rates on one axis and time period on the other axis, and then connected the dots, there should be a “curved” line where the longer time frame has the higher interest rates.
When the yield curve is “flat,” that means that there is something amiss in financial markets. One should get higher interest rates for longer time frame bonds. If the 2 year treasury is paying the same interest rate as the 10 year treasury, the line is not curved, but flat. The yield curve is said to be “inverted” when one gets higher rates on shorter time frames. The line is inverted because it is curving the “wrong” way. The attached graph shows the times when the spread between the 2 and 10 year treasuries become “flat” or “inverted.” Those are times when a recession may be imminent.
One of the nice things about the endowment model, with so many non-correlated asset classes, and such high income, is that we don’t have to worry too much about recessions. The model allows us to rebalance periodically forcing a buy lower and sell higher discipline. However, we are always vigilant, and looking to improve how we construct portfolios. With so much volatility this year… in market, oil prices, international politics, and presidential candidates, we will periodically weigh in with other articles such as this. In portfolio management, information usually trumps (not Trumpertantrums) emotion.
The opinions in the preceding commentary are as of the date of publication and are subject to change. Information has been obtained from a third party sources we consider reliable, but we do not guarantee the facts cited are accurate or complete. This material is not intended to be relied upon as a forecast or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. We may execute transactions in securities that may not be consistent with the report?s conclusions. Investors should consult their respective financial advisor on the strategy best for them. Past performance is no guarantee of future results.
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