Brad Solomon, Junior Investment Analyst
“Bonds Show 60% Odds of Recession.”
It was a bold, slightly jarring headline to an article I happened across one recent morning. I had done a solid minute of skimming before I scrolled back to the top and noticed the published date—October 22, 2011. If the models cited in the article had bet their chips on red, so to say, then the U.S. economy continued to hit black for some time. Over the next four years, the domestic unemployment rate nearly halved while the S&P 500 returned a cumulative 84%. Say what you want about much of that return being multiple expansion (84% total return on cumulative earnings per share growth of 16%)—it would’ve been a tough four years for investors to sit on the sidelines.
I’m writing this from an investment perspective rather than an academic one, but it is still a preoccupation for both fields to monitor to the economy. Why?—because, as quantified by Evercore ISI, S&P 500 bear markets have been more severe (-30%) when they predate what actually morphs into an economic recession versus times when dire signs of economic stress do not ultimately turn up (-15%).
The world is once again on “recession watch” in 2016; signs of financial strain include the offshore weakening of China’s yuan, widening credit spreads, an apparent peak in blue chip earnings per share, and spiking European bank credit default swaps (CDSs). One telling recession indicator, yield curve inversion, has seemingly not reared its head. As measured through the difference between 10-year and 3-month Treasury yields, the spread today stands around 150 basis points, while it has fallen like clockwork to zero or below prior to each U.S. recession since 1956. (Recessions are indicated by the shaded grey areas below, as defined by the NBER.)
A number of commentators have raised concerns that the statistics above should not warrant an “all clear” sense of thinking there won’t be a recession. In full awareness of the folly of claiming that “this time is different”—well, this time may be different. Breaking down the term spread into its two components—the yield on a shorter-dated bill and longer-dated bond—the short rates have been artificially held down by a zero-bound federal funds rate for the past six years, while the feature of positive convexity that is inherently more pronounced for long rates means that it is, in theory, very tough to close the gap” on the remaining 150 basis point spread that would indicate an inverted yield curve mathematically. (A convexity illustration is shown below—the takeaway is that the yield-price relationship becomes asymptotic at high prices, meaning that the 10-year note would need to be exorbitantly bid up to bring its yield down to equate with much shorter maturities.)
So, what are the odds of a recession? If it’s not clear yet, I’m not writing this to assign a current probability but rather to warn against viewing such a figure in isolation. Following the logic illustrated in papers such as this one, statistical programs make it possible to truly fine-tune a model: plug in any number of explanatory vectors (time series variables such as industrial production or unemployment claims) and “fit” the historical data to the response variable, which is essentially a switch that is “on” during a recession” and “off” when not. But as calibrated as the model becomes, there is still subjectivity involved: what is the proper “trigger” for alarm? Should your reaction to a 70% implied probability be different from your reaction to a 60% reading? An important consideration is the objective behind such a model in the first place—to create a continuous distribution (infinite number) of outcomes and assign a probability to a discrete event (red or black, recession or no recession). When framed this way, often it is the unquantifiable, intangible narratives and examination of what’s different this time (rather than what looks “the same”) that can create a fuller picture.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change. Brinker Capital, Inc., a Registered Investment Advisor.