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The last few months have been spent in book promotion mode and as a result, we’ve been blissfully unaware of what’s been going on in the news, especially in the stock market.
But just because I wasn’t paying attention doesn’t mean nothing was happening, because apparently…
Global markets took a left hook to the chin on Wednesday, with the TSX Index shedding nearly 2% over the inverted yield curve.
~Danger, How to Invest After Wednesday’s Yield Curve Inversion, Yahoo Finance
Stocks and oil prices plummeted Wednesday, with the Dow Jones Industrial tumbling 800 points — the fourth largest daily point drop on record and the worst this year.
~Dow plummets 800 points on worsening global recession fears, Fox Business
Sigh. Here we go again.
So once again, in case people have been lulled into a false sense of security about the stock market always heading up-and-to-the-right, this week has been a rude awakening. The stock market is VOLATILE. These kinds of events happen all the time. If you’re going to be an investor in the stock market, you’re going to have to be OK with the occasional 800 or 1000 point drop. If you can’t handle the heat, get out of the kitchen.
And as usual, a big scary drop like this has sent all the talking heads on the news into overdrive trying to predict what it means, and whether the second longest bull market on record is finally coming to an end, and they’re all trying to answer the same question.
Is there a recession coming?
And the answer to that is…YES!
But that’s not nearly as useful or as bold a prediction as it seems. There’s ALWAYS a recession coming up. The stock market (and the global economy in general) is not designed to be steadily increasing in a slow but steady way. It expands, then overheats, then contracts, then recovers, and then expands again. It’s a cycle.
Everyone knows (or should know) that a recession is always around the corner. But the big hairy trillion dollar question that nobody, not me, not the talking heads, heck not even the chairman of the Federal Reserve, knows is precisely WHEN the next recession will hit.
So let’s break down all the stuff that’s been happening in the news and see what it could possibly mean for stock investors.
The Case For an Impending Recession
Reason #1: This Bull Market Has Been Super Long
We’ve all been enjoying a pretty substantial bull run in the stock markets, basically since the end of 2009. This is now the second-longest bull market in history, and it’s made a lot of people a lot of money. The party’s got to end at some point because the economy can’t continue expanding at this pace forever.
Reason #2: The Yield Curve Inversion
The last time the Yield Curve inverted, I called it a bit of a fake inversion. That’s because while the media kept calling it a yield curve inversion, only a small part of the curve actually inverted. This time, however, it’s a much more substantial portion of the yield curve, namely the 10Y versus the 2Y.
And as the media is breathlessly pointing out, yield curve inversions are a pretty solid predictor of recessions. Every recession in the past was preceded by the yield curve inverting, and we’re in that situation now. Therefore, a recession must be right around the corner, right?
Reason #3: The US-China Trade War
And oh yeah, Trump’s in the White House and he’s still fighting with everybody. Specifically, the Chinese.
The US-China trade war is the single largest threat to the global economy, and unfortunately nobody knows how it’s going to end. As I’ve written before, this is actually something I agree with Trump’s positioning on. He’s basically going in there and asking, “Hey, can you please stop stealing our IP?” And China, being China, has responded with trickery, deceit, and a trade war. Again, never trust Communists.
The Case Against an Impending Recession
Reason #1: Bull Markets Don’t Die From Old Age
The argument for a recession based solely on “it’s been awhile, so we’re overdue for one” is overly simplistic. Bull markets don’t end just because they’ve been going on for a while. They end because one of two things happen: The Federal Reserve raises interest rates too high which chokes off the economy, or an external geopolitical shock. And right now, the Federal Reserve is actually doing the OPPOSITE of raising interest rates, so that’s not going to do it. An external geopolitical shock may happen, but as usual nobody can predict when precisely that’s going to happen.
Reason #2: The Yield Curve Is Far Less Useful Than You Think
I’m also not buying the line that just because the Yield Curve inverts, then BOOM a recession has to happen. The Yield Curve is just a signal of trading sentiment in the bond market. Nothing more, nothing less. And when the Yield Curve steepens, flattens, and in this case, inverts, you have to interpret WHY bond traders are trading that way. Are they worried about deflation? Are they worried about the US government defaulting on their debt? Are they worried about unemployment?
In this case, none of those fears are actually manifesting themselves. So why has the yield curve inverted?
Simple. They’re predicting a drop in interest rates.
In June, the Federal Reserve surprised everyone by announcing they’re going to drop interest rates. They’re actually not supposed to do that in a booming economy, but Trump is pressuring them into it for political reasons. That in of itself is a worrying sign because the Fed is supposed to be politically neutral, but when interest rates drop, bond prices shoot up. Specificaly, longer-duration bonds shoot up faster than shorter-duration bonds, so this would have the effect of bond traders dumping short term bonds and buying up longer term bonds. This would cause the prices of short bonds to go down, and long bonds to go up. And because yields move in the opposite direction of bond prices, this would cause short yields (like the 2Y) to go up, while longer yields (like the 10Y) to go down. That’s exactly what we’re seeing. Bond traders are betting on future interest rate cuts, so they’re positioning themselves accordingly.
Does this predict a recession? Not really. Remember, recessions are caused by interest rates increasing too fast, not dropping. So yes, the Yield Curve inverted but I’m not seeing this as a predictor for an impending recession. Quite the opposite actually. I think this will boost the stock market in the short term, and possibly lead to it overheating.
Reason #3: The US-China Trade War Could Still End
Maybe this is the eternal optimist in me, but the US-China Trade War could still end on favourable terms for everyone.
The problem right now is that Trump hasn’t exactly made it easy for China to do it. In Chinese culture, there’s a phrase “saving face,” which essentially translates as “don’t want to look like an idiot”. And however China is going to end this trade war is going to need to allow the Chinese government to “save face” while doing it.
Unfortunately, Trump being Trump has employed his usual “my way or the highway” method of negotiation, and no government wants to been seen as weak and capitulatory, least of all the Chinese. So Trump and his negotiators need to come up with a way for China to say “Yes” to their terms while also not losing face by doing so. It’s not exactly in his skill-set, but I’m hopeful SOMEONE in his administration can come up with something.
What Do I Think Is Going To Happen?
Here’s where I’m going to do the exact thing I’m not supposed to do and try to predict the future. Before we go into that, I’m going to caveat it by saying that this is, like every other talking head out there, a guess. I’m guessing, and in no way shape or form should you make any financial decisions based on what I’m about to say. Stay invested, stay the course, and ignore all predictions. Like the one I’m about to give 🙂
I think the next recession, whenever that comes (which again, nobody knows) is not going to come from the Yield Curve inverting, or Federal Reserve policy, or even Trump doing/saying something stupid. I think the next recession is going to be caused by Beijing.
Like I’ve said, the single largest threat to the global economy is the US-China trade war because of how large and integrated the Chinese economy is in the world’s supply chain. It’s the largest trading relationship the US has, and if that gets blown up everyone loses.
And this trade war was started by Trump not even asking for anything that unreasonable. Just stop stealing our IP and we’ll drop all tarriffs. Any rational negotiator would have sheepishly said “OK, fine.” But the Chinese Communist Party is not a rational actor.
If you’ve read our book, you will know that FIRECracker has a…let’s say complicated relationship with the CCP. They caused a famine, tried to murder her family, they sent her Dad off to a labour camp for 10 years. So let’s go ahead and call that relationship…less than cordial.
And during all that hardship, something the Communists have shown is that they’re really, really bad at admitting when they’re wrong. They deliberately sent the country into a famine in the 60’s when Chairman Mao implemented his first attempt at communism during the Great Leap Forward, and then they tried it AGAIN during the Cultural Revolution in the 80’s. Communists don’t admit when they’re wrong, they double down. And they don’t care if it destroys their economy and kills millions of people. They would rather do that than lose face and be seen as weak.
Which is why how China behaves in the trade war is so important to the world economy. Will they admit that stealing everyone’s IP in the past was a mistake, or will they shoot themselves in the foot rather than compromise?
And that’s why the indicator I’m watching the most closely is not the Dow, or the Yield Curve. Rather, it’s Hong Kong.
Why Hong Kong Is Important To the World
With all the shootings in the US news lately, you can be excused for not paying attention to what’s happening in Asia, but to catch you up, right now Hong Kong is roiled in protests that have basically paralyzed the city for 8 weeks. What started it was incredibly stupid. Basically, the Hong Kong government introduced a bill that would have allowed Hong Kong citizens to be extradited back to mainland China for prosecution. This is very very scary to the people of Hong Kong, because the Chinese justice system has been used to persecute political enemies, so theoretically this bill would have allowed Beijing to arbitrarily arrest anyone in Hong Kong and disappear them.
All the protestors wanted was for the Hong Kong government to withdraw the bill. That’s it. But they refused, instead suspending it from debate, which just delays it from being considered.
Since then, the protests have gotten bigger and bigger, and have morphed into a pro-democracy movement.
Beijing has thus far stayed out of the situation, but they’ve ominously said that if the situation doesn’t come under control soon, they’d be willing to “intervene” militarily.
Here’s the thing: Hong Kong is the financial jewel of China. Not only is it a strategic and historically important trading port, it was the gateway from China to the West. Their transparent judicial system and strong financial regulations allowed investment dollars to flow from rich Western economies into China, and is a major reason that China is now a global economic superpower. In short, Beijing needs Hong Kong. Just like Beijing needs the US.
So how they handle this situation in Hong Kong will be a pretty solid predictor of how they will handle the trade war. Will they make concessions, admit that they’ve made past mistakes, and compromise in order to restore peace to their golden goose? Or will they send in the tanks, kill thousands of people, and crash their own economy in order to not admit when they’re wrong?
I admit I have a personal stake in what’s happening in Hong Kong. While FIRECracker’s family came from Sichuan, mine came from Hong Kong. Watching the city descend into chaos breaks my heart, and I have a vested interest in seeing the protests come to a peaceful ending.
But what’s happening in Hong Kong doesn’t just affect the people there. It affects everyone, because it’s a microcosm of how Beijing is going to behave on the global stage. If they refuse to compromise in Hong Kong, violently crush the protestors, and destroy their own economic crown jewel just to not admit when they’re wrong, they’ll likely do the same in negotiating with the US. What happens in Hong Kong will affect the world.
So going back to the original question, is a recession coming? Eventually. But if you want to know when, I don’t think the answer will be in the Yield Curve. The indicator I’ll be watching is Hong Kong.
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