Since the turn of the year, economic momentum across the globe has continued to fade and concerns about a slowing global economy started to emerge. Following a series of downbeat data, the Fed was pushed to pause on interest-rate hikes this year while the ECB is likely to postpone its plans to implement its first rate hike. Cognisant of the fact that the US, the main driver of the global economy, is a few months shy of entering the longest expansion cycle on record, the probability of a slowdown or indeed a recession seems to have increased.

On March 22 the yield on the US Treasury three-month bill was higher than the yield offered on the 10-year note. This followed the yield inversion of the US Treasury three-month bill and the five-year note back in December 2018, which was the first time the US Treasury yield curve inverted since the Great Recession that started in December 2007. In reality the spread was not material, a mere two basis points, however this is considered by many a gloomy signal for the US economy.

Contrary to the short-end of the yield curve which is anchored to the federal funds rate, the long-end of the yield curve, among other things, is deemed as a reflection of market expectations about how the Fed will move short-term rates in the future. So naturally, during healthy economic periods long-term debt yields more than short-term bills. In this scenario, investors are willing to give up some yield in order for them to have their money tied up for a shorter period of time.

All US recessions in the past 50 years were preceded by a yield curve inversion with the lag between yield curve inversion and recession ranging approximately between 12 and 24 months. Only once did this signal give a false alarm.

But that is not all. There are other ominous signals which are usually associated with a looming US recession. A recently published consumer sentiment measure, which is indicative of future consumer spending – the main driver of the US economy, indicates that confidence is tapering off, albeit remaining higher than the average level registered between 1952 and 2019. Many consumers believe that the stimulative impact of US tax reforms has now run its course. Moreover, a number of analysts believe that the recently published strong US economic growth figure for the first quarter of 2019, albeit at first glance, suggesting that slowdown fears are overstated, does not portray the underlying reality.

At 3.2 per cent the figure stands well above analysts’ forecast. However, according to these analysts this figure has been lifted by one-off factors such as abnormal inventory build-up by US companies and government spending on highways and roads, which when factored out will push the figure down to one per cent. Also of concern is the persisting weak inflation data which might be another sign that the economy is weaker than thought. On the other hand, US jobs data continue to indicate that the US economy is in good health, with an average of 180,000 jobs added during the first quarter of 2019, an unemployment rate below four per cent, and sustained wage growth.

A recently published consumer sentiment measure, which is indicative of future consumer spending – the main driver of the US economy, indicates that confidence is tapering off

In Europe, during the first quarter of the year, the economy has lost more steam than expected. In this case the weakening is attributed to both external and internal factors, ranging from slower global trade growth to increased uncertainty surrounding trade policies to domestic issues such as those experienced by the German car industry and fiscal policy uncertainty in a number of EU Member States. Subsequently, the European Commission has revised the EU GDP growth for 2019 to 1.5 per cent from 1.9 per cent. In addition, recently, the European Commission Economic Sentiment Indicator was cut by a further 1.5 points and now reads 103.7.

This drop resulted from continued lower confidence in industry, retail trade and to a lesser extent, in construction and among consumers. Core inflation in the EU, a closely watched measure for ECB policy makers, continued to slow and the latest reading came in below analysts’ expectations. But there are glimmers of hope. Notwithstanding these developments, the fundamentals of the European economy remain sound and a gradual pick-up is expected to ensue once temporary external and domestic factors currently hindering growth are resolved. On the other hand, improving labour market conditions, a pick-up in wage growth, supporting financing conditions driven by low financing costs and a slightly expansionary fiscal policy stance should support this expansion, albeit at a moderate pace.

How do financial markets perform in this environment?

Amid increasing concerns of a global slowdown, trade and geopolitical tensions and the dovish stance adapted by the Fed and the ECB, risky assets have rallied in the first quarter of 2019. Major equity markets staged a nice rebound with the S&P 500 registering its best first quarter performance in a decade, rising over 13 per cent, and the pan-European STOXX 600 climbing over 12 per cent. Bond markets also followed the same positive trajectory with high yield bonds outperforming investment grade and sovereign bonds.

Going forward, global financial markets remain exposed to changes in perceived economic well-being and investors’ risk appetite. If the current economic environment persists, equity markets will still be supported by expected low inflation, (slower) global economic expansion and supportive monetary policy. Research by BlackRock, a leading global investment firm, reveals that in the 28 quarters that fell into ‘late cycle’ periods since 1988, global equities generated returns above the full-cycle average, beating fixed income. However, investors must be wary of stretched valuations. As monetary policy is tightened, valuations will no longer be supported by central banks and asset prices might experience significant adjustments, leading to a spike in volatility.

On the fixed income front, the current monetary policy stance and lack of inflationary pressures seem to have prolonged the global credit cycle expansion phase. Valuations have recovered from the 2018 lows with carry now expected to take back the reins in generating returns. If, as is anticipated, economic momentum regains traction during the second half of this year and corporate earnings beat current weak earnings consensus, we might see further spread tightening. But significant tightening as seen in the early stages of this cycle is deemed unlikely from this point onward.

Default rates are expected to remain low but investors should be wary of the increased risk within the BBB segment, which has seen substantial growth over the past years. Analysts argue that due to the size of the high yield market these bonds cannot be downgraded without a significant effect on bond prices.

Evidently, major economies seem to be in a very delicate moment. There are signs of weakness which investors, especially money managers cannot overlook. Such times necessitate extra alertness and readiness to switch between asset classes once more economic data become available. Gone are the days when investors sit back and watch all asset classes outperform in tandem. The absence of active management will most certainly lead to late reactions and unnecessary losses.

If we had to compare these signals with our traffic lights system; some of these recession indicators have turned amber but none are anywhere near flashing red. Judging by the past, when they will, it will probably be too late!

Larken Vella is an assistant portfolio manager within Investment Management at APS Bank plc.

The information contained in this commentary represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell / buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments.

APS Bank plc is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

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