Morgan Stanley
  • Wealth Management
  • Jun 3, 2019

3 Reasons to Worry About Recession

Two months ago, it seemed premature for investors to worry much about recession. Now concern is warranted.

It was almost exactly two months ago when we first saw one of the market’s most reliable recession indicators turn negative. I thought it was premature then for investors to worry the economy was weakening, but now I think it’s high time.

The indicator I’m referring to is the yield curve, a chart of Treasury yields from shortest term to longest. In March we saw it invert—meaning long-term rates dipped below short-term rates—for the first time since 2007. Then I cautioned investors not to overreact since I thought Federal Reserve policy swings could have created temporary distortions and weaker economic data might be transitory.

Now evidence recession lies ahead is mounting. I think investors shouldn’t panic and should stick to their long-term asset allocation plan. But opportunities may arise in hard hit sectors like financials, which could rebound if the Fed starts lowering short-term rates and the yield curve rights itself.

Until then, below are three signs indicating a recession could be looming:

  • U.S. economic data is getting worse. The escalation of trade conflicts isn’t helping, but the real issue now is deteriorating growth and worse than expected economic data for retail sales, durable goods orders, manufacturing and more.
  • Credit markets are sending a warning. The yield of a corporate bond compared with a Treasury, a measure known as the spread, has widened. That’s an indication that investors see increasing risk in corporate bonds. It also makes issuing bonds more expensive for both investment grade and high yield companies. That’s one reason our index of financial conditions is getting weaker.
  • Growth sectors are underperforming. Tech leadership is breaking down while defensive sectors like utilities are holding up better. At the same time, small-cap stocks are underperforming large-caps. This rotation in stock sector performance is echoing the yield curve’s message.

An inverted yield curve is most effective as a recession signal the longer it lasts. In March, the yield curve was only inverted for five days. But the current inversion (Last Friday, the 10-year Treasury yielded 2.1% while the three-month bill yielded 2.4%), could last longer. 

When inversions have lasted more than a month, they have successfully predicted all seven recessions in the past 50 years. The average lead time was 12 to 14 months. Recession may not be right around the corner, but it looks increasingly like it is heading our way.

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