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Over the past few weeks, one of the main topics of conversation in the financial markets has been the potential for an inverted Treasury yield curve, which is a phenomenon whereby short term interest rates rise and are actually higher than long term interest rates. In fact, last week, part of the U.S. Treasury yield curve (2yr-5yr) inverted for the first time since the last recession. This event turned everyone’s attention to the most widely followed part of the yield curve: the spread between the 2-year and 10-year Treasury bond. This spread fell to its lowest point during the current market cycle, below 15 basis points, but still remains positively sloped. When the yield curve inverts, lending money becomes a losing proposition, and the flow of lending is curtailed by banks, which in turn leads to slower or negative economic growth.
Inverted yield curves have a high probability of predicting recessions as they have predicted all 9 of the last 9 recessions over the past 60 years. It is quite important to note however, that there is generally a lag between a yield curve inversion and the start of an actual recession. The average lag is 20 months, and the median lag is 17 months. During the 2007-2009 recession, the lag was 24 months. During the 2001 recession, it was 13 months.
Our thought, heading into 2019, is that we are not on the cusp of a recession. While the economy is expected to slow from the 4.2% GDP pace that we saw in the middle of 2018, we still continue to see solid economic numbers, namely manufacturing and service survey data, GDP growth, earnings growth, and wage growth. It will be difficult for U.S. corporations to match the 20%+ earnings growth they have generated lately, but our base case scenario calls for positive earnings growth in single digits, which should translate into positive return on stocks in 2019.
We at Beacon Trust take extra caution to structure and diversify portfolios to withstand the negative effects of a possible recession during the late business cycle. Corrections are normal and expected. We see the most recent correction as a healthy one, removing some of the excesses, especially in some of the higher valuation sectors within the stock market. No one knows for sure what is going to happen in the financial markets next year, but one thing we know is that we manage your portfolios with patience and discipline, keeping a close eye on financial risks as well as Federal Reserve policy. We will make adjustments where it makes sense from an overall asset allocation standpoint while always monitoring the risk vs. reward in the current market in order to provide the best risk adjusted returns for our clients.
Please do not hesitate to reach out to your representative at Beacon Trust with any questions as we are always available to answer them.