Is recession already baked in?

Bob Baur

Bob Baur

After major indices on US stock markets hit all-time highs in July, the plunge in bond yields is bringing increasingly agitated warnings about worsening growth and recession.

Writing in a blog, Principal Global Investors Chief Global Economist, Dr Bob Baur said, “this agonising may simply mean that we are in the worst of the slowdown. We think and hope the odds favour us being in the dark before the dawn”.

A storm before the calm 

“The escalation of trade conflicts and tariffs in August did worsen sentiment and likely delayed further recovery. With uncertainty high, it’s natural for business leaders to shelve long-term capital spending decisions until the trade dustup clears.

“Central banks are in a tizzy, too. More than 30 have sliced interest rates this year, from Botswana to New Zealand to China, with more cuts coming.

“Under pressure from negative interest rates, bank stock indices in Europe and Japan are plumbing 20-year lows while a robust U.S. dollar is putting pressure on Argentina and other emerging markets.

“Still, an encouraging Presidential tweet or lack of Chinese retaliation can turn a vicious down day into a surging rally.”

Signs of progress

Dr Baur noted that there have been several new signs of progress over the past month.

“Bank loans are rising. Initial claims for jobless benefits show no negative trade impact. Layoff announcements are minimal. Wage gains are still accelerating.

“Second quarter corporate profits jumped 5.1% and are now up 2.2% over the prior year, no longer a recession indicator. Consumer spending is robust, up 2.7% over last year and appears on track for a strong gain this quarter. Gas prices are falling, helping budgets. The household saving rate is 7.7%; balance sheets are in fine shape.”

In Europe, where the business confidence shock was the worst, the outlook is modestly positive, according to Dr Baur: “The European Economic Sentiment Indicator rose a few ticks, contrary to expectations.

In China the outlook is also looking up: “Borrowing rates were lowered for small businesses and more fiscal stimulus is likely coming, and global companies most exposed to China are outperforming. Local Chinese equity indices had better returns in August than major U.S. indices.”

Could we talk ourselves into a recession?

“A further downward spiral in sentiment would be trouble. It could start a self-fulfilling cycle of layoffs, puny wage growth, anaemic consumer spending, and lousy profits.”

However, Dr Baur thinks that it’s too early to plan for recession within the next year. “The record- long U.S. expansion still has legs (see: a healthy labour market and vigorous wage gains supporting consumers).

“China is adding to its fiscal and monetary stimulus. Central banks stay very accommodating. Financial conditions have eased. There is little stress in credit markets.

“We expect a mild pickup in world growth in the fourth quarter”.

Looking ahead

“The most disturbing feature of the year to date has been the relentless nose-dive in long-term safe- haven bond yields. From a peak of 2.8% last January, yields on 10-year U.S. treasury bonds ended August at 1.5%.”

The fear generated by the plunge won’t vanish easily according to Dr Baur, who anticipates “Central banks will lower rates further. The Fed will cut the funds rate by at least 0.25% in September…. The European Central Bank will drop its official rate more deeply into negative territory and probably restart bond purchases in September.

“Even if inflation does inch higher, which we expect as the slowdown fades, central banks will stay accommodative for a long time.”

“Long-bond yields are too low even for the current environment, but they will likely not advance without clear evidence of a pickup in growth.

“With any trade resolution unlikely soon, the erratic markets of August may persist into October… If that’s the case, U.S. treasury yields could retest the lows of 2012 and 2016. Beyond that, government bond yields are surely tracing out a trough that will hold into 2021.

“Regarding equities, most world stock indices are ahead for the year, thanks to the turnaround in central bank intentions and the collapse in interest rates.”

However, volatility “will likely continue until a definite recovery of world growth becomes evident sometime in the fourth quarter”.

“As trade tension and growth worries have intensified, investors rotated into defensive sectors taking them to valuation extremes relative to the rest of the market.

“We’ve advised caution for many months and still believe it’s the right touch. Without a recession, it’s hard to imagine U.S. treasury yields going much lower from here.”

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