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Craig Jerusalim, senior portfolio manager, Canadian equities, at CIBC Asset Management.
Now that the yield curve has inverted, every news outlet around is decrying fears of an imminent recession, but before you go out and sell all of your risk assets, I would suggest stepping back and taking a more holistic view of the North American economy rather than utilizing a simple rule of some indicator like the yield curve. First of all, the yield curve inversion does not cause recession. It has just preceded recessions due to the circumstances at the time, of lower perceived growth and the flight to safety of Treasurys.
Additionally, we know that the timing mechanism from inversion to recession has ranged from 12 to 24 months on average, so not the greatest timing tool. But most importantly, today’s environment is unlike anything we’ve experienced in the past. There is about $17 trillion of negative yielding government debt dragging down rates in North America, in addition to ongoing quantitative easing, both of which are sending mixed signals as they distort interest rates along the curve. That is why we need to examine some of the other economic indicators we have at our disposal before writing off the cycle and potentially missing out on some decent upside.
There are six other key indicators that I would point to in order to make a more informed decision. Jobs, housing, PMI or purchasing manager indices, credit trends, small business confidence, and the overall health of the consumer.
Starting with jobs, U.S. continuing job claims have started to modestly edge higher, but they are coming off such depressed levels that it is hard to say that this is a warning sign. A better indicator is the U6 unemployment rate, which incorporates the unemployed plus those no longer looking for work, as well as those unable to work as much as they’d like. In the U.S. this measure is 7%. And although it is as low as it has been in decades, it is still falling as workers who had left the workforce are re-entering to the increased levels of optimism, so nothing to worry about here.
Housing is an important indicator because an overbuild in housing can cause prices to fall, which often proceeds recession. The good news here is that housing starts post the financial crisis haven’t even made their way back to the long-term average, despite the larger population today. Plus housing permits, a better leading indicator, continues to show positive trends higher.
Purchasing manager indices are indicators often used to assess the health of the economy. A level below 50 indicates contraction while a number above 50 indicates expansion. Bears often point to manufacturing PMIs, which have fallen below 50 in the United States and globally. However, when combined with the more relevant servicing component of the economy, we are still in expansionary territory, despite recent debt. This is something that we will definitely need to keep an eye on moving forward.
Financial markets are also still showing accommodative conditions and investment-grade corporate spreads are still showing quite benign credit trends. Spreads have widened from historic lows but are still well below long-term averages and nowhere near levels that would raise red flags.
Small businesses are the engine of the U.S. economy and small business optimism continues to hover at robust levels, this bodes well for hiring, investments and future growth.
The final indicator is the health at the all mighty consumer, and any way you assess this group, be it consumer confidence, savings rate, consumption, the trends are still fairly positive.
So summing it all up, even if your gut instinct is telling you to sell equities at this point in time, the evidence is still pointing to economic expansion despite what CNBC, Twitter, and some ex-Fed members are saying. Over the long term, market timing has proven a very poor strategy. Instead, stay invested in high quality growing companies with prudent balance sheets and defensible competitive positions in order to reap the benefits of long-term capital compounding.