Global Asset Allocation Update

The risk budget is unchanged this month. For the moderate risk investor, the allocation to bonds and risk assets is evenly split. There are changes this month within the asset classes.

How far are we from the end of this cycle? When will the next recession arrive and more importantly when will stocks and other markets start to anticipate a slowdown? These are critical questions for investors and ones that can’t be answered with a high degree of certainty. History may not repeat but is said to rhyme so probably the best we can do is look to the past for a clue about the future. 

The yield curve is often cited as the best recession indicator and we agree with that assessment. But it is easy to misinterpret and most people do. Everyone knows the yield curve inverts prior to recession – or at least it has for a long time – but the lag time can be considerable. In the last cycle the 10/2 curve first inverted in February of 2006 a full 18 months prior to the official onset of recession. The S&P 500 still had 21% more upside at that point. In the 90s the curve first inverted in June of 1998, almost three years – and over 30% in gains for the S&P 500 – before recession. 

While an inversion of the yield curve is important it isn’t the signal for recession. The more timely indication is a steepening of the yield curve known, ironically, as a bull steepener. That occurs when short-term rates fall faster than long-term rates. This situation generally reflects an expectation that the Fed will cut short-term rates. In the last cycle, the maximum inversion came in November of 2006 and the curve turned positive for good in June of 2007, just 5 months before recession. The Fed’s first rate cut came in August of the same year.

Of course, we aren’t even close to that circumstance presently. The fed is widely expected to hike rates two more times this year and the 10/2 curve is at 35 basis points and falling. The comparable period in the last cycle was in the summer of 2005 over two years prior to recession. All cycles aren’t the same obviously and the 1990s business cycle saw the curve at present levels as early as December of 1994, over six years before recession. So we may be two years before the next recession but that is in no way a prediction. As I’ve said many times, I can’t predict the future and the present isn’t as easy to interpret as most people seem to think.

Assuming that the curve will invert prior to the next recession and that the timeline for this inversion is similar to the last cycle involves way too many assumptions for my taste. The yield curve does not have to invert prior to recession; this isn’t science which sets out hard and fast rules. We don’t even know if the curve will steepen prior to recession. Long rates and short rates could fall at the same rate which might tell us an even worse story than a mere recession. 

Luckily, we don’t need to predict the exact onset of the next recession. In the last cycle stock prices within 10% of the ultimate monthly closing high were available from November 2006 to May 2008. In other words, you had an 18-month window within which you could have exited the market within 10% of the high. Precision was not required. 

Right now the yield curve is not acting in any way like a recession is on the horizon. Neither is our other major indicator, credit spreads. That doesn’t necessarily mean that stocks will go up from here and it doesn’t rule out a bear market either. There have been bear markets without a recession although that is rare. But recessions without bear markets? That is even more rare and not worth hoping for.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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