And if yes, why would that matter for an investor? Well, during a recession economic output goes down and consumers tend to buy less goods and services which generally reduce company earnings and lower earnings result usually in lower share prices. A recession in the US has usually ripple effect on other countries due to the high integration of international trade and the importance of the US as the largest economy in the world and the largest share market with around 50 % of world market capitalisation. So a sneeze in the US economy could well translate into pneumonia in the Australian economy (so the picture goes) and this could lead to a fall of Australian share prices. Australia already has underperformed world equities considerably since the GFC bottom and looks already quite weak.
The world economy and particularly the US is quite strong (with maybe pockets of weakness in Europe) and pleasing GDP growth but is this as good as it gets? We are currently in a US quarterly reporting season and results so far are quite good due to the strong economy and Trump tax cuts with many analysts forecasting 17 % to 20 % earnings growth in the S&P 500 companies. But the stock market is not really interested in the past but projects 6 months to 12 months into the future and there are some worrying signs looming.
The first problem will be next earnings quarter to beat the current quarterly earnings. There is only so much growth out there and some analysts fear that coming quarterly earnings cannot keep up with the current good run resulting in earnings misses and lower guidance. This would then lead to lower share prices. And yes, this is quite a possibility.
Another area of concern is interest rates in the US. There is something called a ‘yield curve’ which depicts the market interest rates for fixed interest products / bonds across the maturity spectrum starting from overnight funds and going to 3 months rates, 2 year Treasury Notes, 5 years, 10 years all the way to 30 year Treasury Bonds. A normal yield curve has lower rates on the short end (overnight to 5 years, let’s say) and higher yields on the long end as investors will usually require a higher return for more risky, longer term investments. But currently the yield curve is flattening. That means that the difference between 2 year and 30 year rates and 5 year and 30 year rates is vastly reduced. The normal difference is in the 200 – 300 basis point range (2.00 % – 3.00 % points), i.e. 30 year yields are 2.00 % – 3.00 % points higher than 2 year or 5 year rates to compensate for the higher risk. Currently, however, with the tightening on the short end by the Federal Reserve the short end rises relatively fast but the long end doesn’t so that the difference is now roughly 50 basis points and quickly approaching 0 basis points (0 % points). This is called a flat yield curve and relatively unusual.
But it can get even worse, i.e. the yield curve can become inverted. That means that short rates are higher than long rates. This happens in a recession. Then consumers buy less goods and services, companies don’t have pricing power and cannot raise prices resulting in lower inflation. Interest rates reflect inflationary risk with rates being higher when high inflation is expected and rates being lower when lower inflation is expected. As the short end yield rises through Fed tightening the long end doesn’t rise much as investors appear not to be too worried about inflation in the longer term. If they were, interest rates on the long end of the yield curve would be higher.
Now the risk is that the relatively unusual flat yield curve will invert. This hasn’t happened yet but analysts are worried that the inversion could happen late 2018 or early 2019. An inverted yield curve is one of the best leading indicators for a recession. Last time the yield curve inverted was in 2016 and it took then two years until the great GFC recession. Stock markets will anticipate just that forecasting up to 12 months out so with an inversion a stock market top should / could follow soon.
The yield curve is one of the indicators I follow closely and use it as one of several early warning signs.