INSIGHTS

Substantial falls in sharemarkets are rare outside of recessions, as they usually require a large decline in corporate earnings, and that usually involves a contracting economy.

With this in mind, investors are often focused on trying to predict the timing of the next recession. While this is a difficult task, there are indicators that have proven useful in the past. One of these is the 'yield curve'.

The yield curve is a line on a chart that plots interest rates or ‘yields’ over different maturity dates. Under normal circumstances, long-term rates are higher than short-term rates, as investors demand greater compensation for locking their money up for lengthier periods of time.

However, when bond investors see lower growth (or a recession) ahead, they become more comfortable accepting lower interest rates for longer-term bonds.

This increasing willingness to accept lower interest rates several years in the future sees longer-term rates fall below the prevailing short-term rate, and the yield curve becomes ‘inverted’.

One widely followed part of the US yield curve has become inverted in recent days, adding to market volatility and causing many to ask themselves if the US is headed for recession.

For those inclined to take a glass half empty view, there is no shortage of things to worry about. In addition to the high profile trade war that has been escalating between the US and China, one can point to the tensions in Hong Kong, Argentina’s political issues and the ongoing Brexit saga.

We’ve also seen a slowdown in Chinese imports and some soft domestic indicators, that tells us it’s not only trade concerns impacting the world’s second largest economy. Manufacturing remains in the doldrums worldwide, with almost all indicators suggesting the sector remains in contractionary territory.

On the other side of the coin, other reliable predictors of recession, such as leading economic indicators and changes in the US unemployment rate, are not sending the same cautious messages.

If a major slowdown is looming, no one has told the US consumer. Retail sales for July were much stronger than expected this week, surging 0.7 per cent for the month compared with 0.4 per cent in June and forecasts for a slowdown to 0.3 per cent.

This followed a very strong consumer confidence report in July, with the index rising well ahead of expectations to 135.7 from 124.3 in June. It also wasn't far below the 18-year high of 137.9, which prevailed in October last year.

We also need to acknowledge the increasing influence of global central banks on interest rate markets in recent years. With capital markets so interconnected these days, the actions of policymakers in Europe and Japan may have artificially depressed longer-term interest rates.

Finally, the intense interest in the yield curve that investors and commentators take these days may have diminished its usefulness as a predictor of what’s to come.

We’re keeping a close eye on all economic indicators at the moment, including the yield curve. At the same time, we’re reluctant to let this red flag define our investment strategy.

Global sharemarkets have fallen from their highs in recent weeks, and there’s a good chance we see further weakness and more volatility from here. However, that doesn’t necessarily mean we’re headed for a full-blown recession or bear market in the months ahead.

Signs of progress between the US and China could quickly turn sentiment around, while a rate cut or two from the Federal Reserve in the US would change the shape of the yield curve overnight. Both of these outcomes are possible, suggesting that level heads are required despite some of the risks.