Many investors have been puzzled for most of this year by an inverted US yield curve, which along with economist forecasts and CEO surveys signals an impending recession. At the same time, the performance of risk assets suggests a much brighter outlook. Which is right and which is wrong?
Despite negative investor sentiment, equities have outperformed government bonds so far this year (see Exhibit 1), as has corporate credit (notably high-yield). Consensus forecasts have consistently projected rising earnings instead of the declines one typically sees in a recession.
One possible explanation for the apparent divergence in views between the markets could be simply that one market is right and the other wrong and that eventually they will converge. Assumedly, equities will fall once the market ‘realises’ a recession is actually in store (as we believe). While convergence is possible, it seems unlikely to us that markets could sustain such a schizophrenic view for so long.
How to reconcile the opposing stances?
There is an alternative explanation: interpreting the inverted yield curve as a recession signal is incorrect. While it is true that historically an inverted curve has often been followed by a recession, it is not inevitable that recession will follow.
The inverted curve simply reflects
- High interest rates today as central banks aim to slow economic growth and hence inflation
- Lower rates in the future once growth and inflation decline.
That is, the inverted curve (accurately) forecasts a slowdown in growth, but that slowdown does not have to end in recession. This is not to say current bond market pricing excludes the chance of a recession, just that the markets reflect a scenario where the probability of a slowdown is greater than the probability of a recession.
There are two reasons why things may be ‘different this time’, with the inverted yield curve not being followed by a recession.
The Fed is aiming to steer the economy to a soft landing, so it may err more on the side of letting inflation stay higher for longer rather than raising rates even more aggressively to get inflation back to its 2% target quickly. It is worth noting that the June monetary policy meeting, the Fed not only held rates steady, but it also raised its inflation projection for 2023.
The other key difference is that the US economy is in a different state than during previous slowdowns. Thanks to fiscal stimulus, consumer demand has remained strong. The first-quarter drawdown in inventories actually reflected that strength in consumption.
If GDP growth is expected to slow merely to a below-trend rate, it is perfectly reasonable that equities should rise and that earnings are forecast to grow in the year ahead. Even with a recession, the economy is still expected to grow by 3% in nominal terms in 2024.
US consensus earnings forecasts have already been revised down and call for flat earnings growth (ex-energy) this quarter. For the rest of the year and into 2024, however, expectations are much higher: 6% for the third quarter, 13% for the fourth, and a similar rate for 2024 (see Exhibit 2).
In our view, these forecasts are likely still too optimistic.
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