Early last week, global equities hit a five-month high. Then they had another growth scare. The US Federal Reserve warned that the US economy had slowed and said it would not raise interest rates this year. A gauge tracking Germany’s manufacturing sector slipped to its lowest level in six-and-a-half years.
Also, the IHS Markit Purchasing Managers’ index also fell below 50, the level that separates expansion from contraction. The final element of the triple whammy was the inversion of the US yield curve. The FTSE 100 slipped by 2% and Asian markets fell slightly further last week, notching up their worst week since November.
The yield curve plots the difference, or spread, between the yield on the ten-year US Treasury (government bond), and the yield on the three-month Treasury. It therefore shows how much it costs the US government to borrow money over ten years compared with three months. In normal times, the interest rate on loans rises with the lending period, so the yield curve slopes upwards.
Spooked by the yield curve
The yield curve inverts when long-term interest rates fall below the level of short-term ones. This means markets think interest rates will be cut, which is almost always the result of a recession. Since World War II, every recession has been preceded by an inverted yield curve. But, as Gavekal research points out, not every inversion has been followed by a recession – “there have been cases of false positives”. The recent inversion may be a “false alarm”.
The macroeconomic backdrop certainly doesn’t suggest an imminent recession. As the former Fed chair Janet Yellen told the Financial Times, the central bank is still pencilling in growth of 2% this year, which hardly amounts to “a dangerous situation”. US growth may have slowed but it has hardly fallen off a cliff.
Across the Atlantic, the eurozone as a whole is faring reasonably well, says Andrew Kenningham at Capital Economics. The services and construction sectors are proving more resilient than manufacturing –“even in Germany”. What’s more, there are signs that wage growth continues to be strong around the world. This should support consumption as well as inflation. Central banks remain supportive, with the Fed on hold and the European Central Bank announcing more credit for European banks.
There is still time
Even if the yield curve inversion does herald a recession, history suggests that a US recession is still about 12 months away. In the meantime, the US stockmarket can continue to rally, as it did in 2007-08, bolstering global equities. Growth scares, moreover, are good news for bargain hunters, who should be eyeing up Britain. As Tom Stevenson says in The Daily Telegraph, the UK is now “cheaper, whatever your preferred measure might be”, than Europe, the US, Japan and emerging markets. “Home bias has never looked more sensible.”