Asset manager warnings of a US recession in 2020 may be overdone if one key indicator is to be believed, according to Neptune Investment Management’s James Dowey. 
As the US economy has continued to power forward – further boosted recently by president Donald Trump’s tax breaks, applying stimulus at a time when little has been required – investor nervousness about the end of the economic cycle has increased.
Yet, Neptune’s Dowey said the ‘2020 recession’ narrative that has been developing among asset managers may not be the right call.
“A lot of asset managers are coming out and saying ‘recession in 2020, put it in your diary’,” said Dowey. “Obviously that’s a slightly heroic thing to do: you can’t predict recessions in that way.
“To some degree they’re slightly politically-motivated in doing so because if you get a recession in 2020 – particularly if the economy is struggling in the second quarter – then that is likely to have a bigger impact on the election outcome.
“If you take growth in the second quarter of the year it – alone of anything else in any election ever – would be the single best predictor of the election outcome... because of the data lag and then taking that narrative being formed as opinions coalesce regarding the economy.”
Post-war US presidential election results
Source: OECD
“What I would say is I wouldn’t want to push too hard on the 2020 narrative – I would push back on it in a technical way.”
Dowey said a far better indicator of recession for the US economy is the 10-year minus two-year Treasury spread – the term spread – which is the “number one recession indicator”.
The Neptune chief economist noted the spread has fallen in recent months close to post-crisis lows and is close to inverting, which has, in previous years, foreshadowed a US recession.
“What it tells us is that when it inverts there is a recession within the next 12-24 months,” said Dowey. “It is the number one recession indicator bar none and right now it is flashing amber with a hint of red.
“It’s going to invert probably over the next six months or so... and we’re going to be in recession signal territory.
US 10yr-2yr Treasury spread since 1976
Source: Neptune Investment Management
“It would be complacent to waive this away and say ‘Well, this time it’s different. It’s worked in the past but this time it’s different for this reason’,” explained the Neptune chief economist.
“That’s what [Federal Reserve chair Ben] Bernanke did in 2006 and it worked right until the recession came around in 2008.”
However, Dowey noted that while the firm does put a lot of weight on the indicator there are additional factors that investors should take note of.
The Neptune chief economist said there are two components to the term spread: one, inflation and real rate (growth/recession) expectations; the other is the ‘term premium’ – the inflation and real rate risk premium, demanded by investors for holding Treasuries.
While the growth/recession expectations component remains positive, the term premium has fallen dragging the yield curve downwards, as the above chart shows.
“What we’re seeing this time around is that the term premium has collapsed as a recession indicator and that is very strongly linked to QE [quantitative easing],” he said.
As such, the unwinding of the Fed’s balance sheet could see the term premium increase over time.
While it remains unclear whether a recession is likely to emerge in 2020, Dowey said it is “too early to run and hide” urging investors to remain pro-risk.
However, there is one asset allocation issue that investors should be aware of if the prospect of recession continues to intensify, particularly as markets moving from a deflationary environment to an inflationary one.
“From an asset allocation perspective there is one enormous implication from this and this is that bonds are no longer going to play the risk management tool they’ve played so wonderfully for the past 20 years or so,” he said.
“Bonds have been everybody’s friends for the past 20 years because they’ve had a negative correlation to the stock market but that’s not going to be the case anymore going forward.”
Indeed, Dowey said that when you have an inflationary recession both stocks and bonds are likely to fall together as opposed to a deflationary recession where stocks fall but bonds rise, which was seen more recently during the sell-off in markets earlier this year.
“We should not be too surprised about this if we do our homework, the correlation between stocks and bonds over the long run is much more typically a positive correlation,” he explained.
Source: Neptune Investment Management
“It’s only been over the past 20 years or so and during predominantly inflationary conditions [that they haven’t]. More often than not, stocks and bonds have gone up and down together and this is what investors need to get their heads around over the next 10 years.”
As such, the Neptune chief economist said the firm prefers inflation-protected bonds because it gives investors duration to real conditions and provides it a hedge to equity-dominated portfolios.