Cyclicality is one of the underlying inevitabilities of macroeconomics and, after one of the longest bull markets in U.S. history, the U.S. economy is finally showing signs that it has entered a late cycle phase.
The first of these signals is one of the classic tell-tale recession indicators - an inverted yield curve. Sections of the yield curve have been inverting since November of 2018, and now the 3-month treasury bill yield has dipped below the 10-year treasury bill yield for the first time since 2007. Additionally, many European countries now have inverted yield curves and multiple countries in Asia have flat yield curves that could invert in the near future. These suggest high uncertainty in the global markets. Some experts suggest that the current U.S. yield curve inversion is not a concern because it was caused by a dip in the 10-year yield, rather than a rise in the 3-month yield. However, an inverted yield curve has only been a false alarm once in the past five decades, which shows that it is rarely ever “different this time.”
Another signal is a high proportion of financial service professionals who have yet to see a significant market downturn, which is chiefly due to the length of the bull market. This is also true of financial service companies in general, which is reflected by the record numbers of active private equity funds in the market. These facts suggest that when a market turn occurs, many investors will be unprepared to respond.
The final indicator is increased corporate leverage. In a previous article (A Look at Corporate Leverage) we noted that some of the reasons for increased corporate leverage may be relatively benign. However, there are a few causes for concern. Most notably, the spread required by investors for investing in BBB-rated credit versus A-rated credit is relatively low. This has caused BBB-rated and similarly rated companies to increase their leverage to questionable levels.
Whether or not a recession occurs within the next year, an eventual downturn is unavoidable. With many indicators suggesting that the market is in a late cycle phase, it may be time to start adjusting risk appetite in order to better reflect future uncertainties.