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September 2019 Client Letter

Talks of recession fears have come up more often in my discussions with you over the past few weeks, so I thought it may help for me to spend some time talking about the current climate, what may be causing investors to be nervous about recessions, some history on recessions, and my thoughts on what we should do as investors to prepare for a recession.

What is a Recession?
A recession is a contraction in economic activity, typically lasting more than 2 quarters (or 6 months).  Recessions are a normal part of the business cycle and typically follow a lengthy period of economic expansion.  As a result of expansion, when inflation picks up, central banks will try to reduce inflation through raising the cost of short term borrowing.  Typically, recessions are triggered when either a) central banks raise rates too fast, or b) some other sudden shock to the economy (like a credit bubble bursting, oil crisis, housing crisis).  

What has People Worried about a Recession Today?
Recession forecasters have been pointing to the recent inversion of the yield curve in the United States.  A quick tutorial on the yield curve:  The yield curve measures the yield, or total return, you are getting on bonds of differing lengths (ie. 2 year bonds vs. 10 year bonds).  The most closely watched yield curve at the moment is the one that plots US Treasury bonds.  The typical shape of the yield curve is a gentle slope, up and to the right, which means that short term bonds are yielding less than long term bonds.  A normal yield curve tells us that investors demand a higher return to have their money locked away in longer term bonds because they expect to have better opportunities to invest those funds elsewhere (ie. stocks). 

When the yield curve flattens, or inverts (goes upside down) - that means that investors as a group are expecting tough economic times ahead and are shifting their money into longer-term bonds, which drives up the bonds' prices and drives down their yields.  (Yes, I know this is a bit confusing).  Basically, an inverted yield curve means that investors as a large group are fearful of the near term and want to hide out in safe assets like longer term government bonds.

How reliable is the Yield Curve as a Recession Indicator?
In the US, a yield curve inversion has been a good indicator of a coming recession for the past 5 decades.  The average time between the inversion of the yield curve and a recession has been about 18 months, but recessions have come as quickly as a few months, all the way out to about 33 months.  So, using a yield curve inversion as a timing tool to jump in and out of the market is not a great strategy historically.  In Canada and around the globe, inverted yield curves have not been as reliable at calling recessions.  

Eugene Fama and Ken French published a paper that explored the relationship between yield curve inversions and future stock returns around the world since 1975.  In the study they compared a simple "buy and hold" strategy of holding onto stocks when the yield curve inverted vs. moving funds from stocks to treasury bills (short term bonds) when the yield curve inverted.  The did this comparison in the US and around the world, and concluded that when the yield curve inverted, that investors would have been better of to stay with buy-and-hold.

"Inverted yield curves, with higher yields on short-term government bonds, tend to forecast future recessions. Perhaps because of this relation, some investors, fearing that an inverted yield curve predicts low stock returns, reduce their equity exposure when the term spread is negative. We test whether the fear is justified. The answer is no. We find no evidence that inverted yield curves predict stocks will under-perform Treasury bills for forecast periods of one, two, three, and five years" - Fama and French

What can we do to prepare for a recession?
The best protection against a recession or any market volatility is to have an up to date and clear financial plan, and an investment strategy that is tailored to that plan.  Only when you have a plan in place can you ignore the short term fluctuations in your portfolio, knowing that volatility is a feature of investing in markets and not a bug.  Trying to time entrances and exits from the market based on recession fears or any other external influences is, historically, a formula for regret.

As always, I am here to discuss this with you in more detail. 

Thank you for your trust,

Mark

Photo by Ashley Knedler on Unsplash

The information in this material is not intended as investment, tax, or legal advice.  Please consult your advisor or tax professionals.