60% of the Time, It Works Every Time

Solomon-(2)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.)

Source: The Federal Reserve, Brinker Capital

Source: The Federal Reserve, Brinker Capital

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.)

Source: Brinker Capital

Source: Brinker Capital

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.

Investment Insights Podcast – Why So Shaky, Markets?

miller_podcast_graphicBill Miller, Chief Investment Officer

On this week’s podcast (recorded January 7, 2016), Bill lends some insight into why markets have started the year so volatile, and what that means for the long-term outlook.

Two themes are at the heart of the current market weakness: (1) Chinese government has meddled too much with its market and currency and (2) Central banks have kept interest rates too low for too long.

China

  • Stock prices are two to three times more expensive relative to Germany, U.S., Japan and others
  • China halted trading (twice) so investor’s couldn’t get to their investments, causing panicked behavior among investors
  • Officials manipulated down the value of the yuan in an effort to stimulate exports, creating more fear in investors
  • Things must be weak enough where officials think that they have to stimulate exports

Central Banks

  • Central banks around the world have kept interest rates near zero, but now that is shifting
  • U.S. has raised rates and there is talk of raising them again in 2016; but Europe and Japan remain at near-zero levels, creating a credibility issue
  • Investors now questioning why U.S. is going in one direction and Europe and Japan in another, and what that means to their investments

The combination of Chinese market manipulation and central bank credibility is surely causing fear, and perhaps some irrational investing, but it’s important to temper those voices. While the current volatility may take some time to pass, it feels more like a market correction and less of a large-scale economic issue.

Click here to listen to the audio recording

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.

Investment Insights Podcast – Here Comes the Renminbi

miller_podcast_graphicBill Miller, Chief Investment Officer

On this week’s podcast (recorded November 20, 2015), we focus on the likelihood that the International Monetary Fund (IMF) will add the Renminbi (RMB) as an approved currency in its Special Drawing Rights (SDR) basket. Will this displace the U.S. dollar as the world’s reserve currency?

What we like: We don’t believe the RMB will supplant the dollar as the favored reserve currency, at least not anytime soon; law and precedent in our judicial system is more structured and supportive–not the case in China; debt markets aren’t well-developed in China; Chinese don’t necessarily want the RMB to be a much stronger currency relative to the U.S. dollar as it would impact their ability to export; approval would likely lead to more reform in China, which would add to global stability

What we don’t like: This won’t necessarily solve China’s current growth problems; would likely have some type of ripple effect (Australian dollar)

What we’re doing about it: Standing pat; announcement may come soon, but would not take shape for another year or so; no need to rush into portfolio changes; not a major concern to the U.S. dollar at this time

Click here to listen to the audio recording

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.

The Future of the Yuan and its Impact on the Dollar

Stuart QuintStuart P. Quint, CFA, Senior Investment Manager and International Strategist

The consideration of adding the yuan, or as others may refer to it more formally as renminbi (RMB), as the fifth member to the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) list has been debated for many years. However, while it is expected that China will eventually have its currency recognized by the (IMF), the question is timing of this conversion.

The recent crash of China’s stock market, combined with strong state intervention of measures that go against the grain of market liberalization, has the potential to delay acceptance of the yuan. That’s not to say that the central bank won’t want to proceed as proposed, but competing forces might gain strength in calling for a go-slow approach in making the decision.

In the near term, the adoption of the yuan would likely prompt U.S. dollar selling. China is experiencing weaker growth, and monetary policy is easing while the U.S. is stable to getting tighter. The appetite of central banks to dump dollars in favor of yuan will take time. However, over the long term, the yuan could be the major competing currency to the U.S. dollar–if China can conduct further structural reform that restores confidence in more sustainable growth.

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, a Registered Investment Advisor.