Why are markets acting like recession is looming?

An investor who ignored economic releases and instead focused on equity and bond markets might be led to believe the economy is shaky, on the cusp of sick. Even aside from the well-publicized flattening of the yield curve, investor behavior looks particularly cautious. During the past three months, U.S. Treasury and German bond yields have fallen approximately 30 basis points (bps, or 0.30%), industrial metal prices have collapsed and defensive sectors, such as healthcare and consumer staples, have trounced their more cyclical cousins, notably energy and materials.

Yet U.S economic activity looks solid, bordering on strong. Second quarter gross domestic product (GDP) growth was the fastest since late 2014, household consumption is surging and industrial production is recovering from the manufacturing recession of 2015-2016. Looking at more forward looking measures, business confidence is high and the residual impact of tax cuts and fiscal stimulus should produce a strong second half.

So why are investors behaving as if the economy is slipping towards the abyss? 

1. Weakness outside of the United States.

Everyone is painfully aware of the travails in Turkey and Argentina. The truth is that in addition to a few vulnerable emerging markets, there are other pockets of weakness, albeit less severe. Europe and China are decelerating. Global growth (G-8) estimates peaked in March and have been slipping ever since.

2. Reality has not met expectations.

As strong as the economy is, even in the United States economic releases have not quite kept up with overly aggressive forecasts. Economic surprise indexes, which measure reported economic data relative to expectations, are now falling in the United States and are negative in much of the rest of the world (see Chart 1).

3. There are some yellow flags.

While the economy is strong, there are warning signs. The most obvious is trade disputes. While the immediate effects of rising tariffs and tensions have been negligible, nobody really knows how far this will go or how escalation may slow down certain segments of the economy, notably capital spending. Beyond trade, there are also two other areas worth watching: U.S. housing is sliding and manufacturing may have peaked. On the latter, it is worth noting that ISM New Orders, an indicator that typically leads the economic cycle peaked in December. While past peaks have often meant little more than a mid-cycle slowdown, they can also be indicative of a cyclical top, particularly when combined with a flattening yield curve and widening credit spreads.

The bottom line

Outside of the yield curve, there are few indicators that suggest a recession in the next 6-12 months. Recent weakness appears more a function of a deceleration in ex-U.S. growth and tariff-induced fears–along with a failure to meet overly optimistic projections. That said, there are a few early warning signs to note. While probably early, a bit more defensiveness is not irrational.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

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