The world economy is not in a healthy state at the moment. The war in Ukraine is predominantly a human tragedy for which one hopes for a resolution soon. It is also redrawing the geopolitical and economic outlook for western economies.
Runaway inflation is stoking the fire, and is turning out to be anything other than transitory.
Now, the first warning signs are emerging in the US bond market that a recession could be imminent. Here, I want to touch on this and explain what I am doing with my portfolio.
Yield curve inversion
The US bond market is basically a vehicle whereby investors lend money to the federal government. The yield that an investor can expect to earn is linked to the duration of that loan. This stretches from as long as 30 years to overnight (known as the Fed funds rate).
Recently, the spread in the critical 2-year vs. 10-year rate went negative. In other words, the interest rate on a 10-year bond fell below that for a 2-year bond.
So, why is this such a big thing? Well, every time the yield curve on this spread has inverted, it has led to a recession and a subsequent stock market crash. In recent history, this includes 2006 and 2000.
Is a recession now inevitable?
Like all stats, one must be careful not to extrapolate too much. The US bond market, like the stock market, is driven by supply and demand. There are several dozen combinations of spreads in the Treasury curve, for which the 2 vs. 10s is just one. At the moment, less than a third of the combinations are inverted.
Personally, I am much more inclined to keep an eye on the 10-year Treasury yield. This is the lynchpin. For the best part of four decades, it has been trading in a downward channel. I don’t expect that to continue.
The unprecedent stimulus package and money printing by the federal government, has created a debt-to-GDP ratio that has not been seen since the 1940s wartime era. On top of that, we have inflation at multi-decade highs and valuations in US equities that have reached insane levels.
The Fed is now going after inflation. Interest rate rises are inevitable. How high they will go is the big unknown. With all the imbalances in the economy, if they raise them too high, a stock market crash is inevitable. If they are too cautious, then inflation will continue its upward march.
What am I doing?
Unsurprisingly, I am not buying any growth stocks, particularly the FAANGs and software companies. Their future cash flows in a rising interest rate environment are highly uncertain. Indeed, I believe we have already seen the peak in US equities.
What I am buying is tangible assets. The prospects for oil and gas companies are the best they have been in decades. Base metals and agricultural commodities are also in my portfolio. But I am also buying precious metals. Not directly but through buying shares in mining companies. In high inflationary environments, gold and silver has proved themselves time and time again as perfect hedges.