Inflation continues to spiral out of control, the yield curve is close to inversion, and the US Federal Reserve is expected to increase interest rates at least seven times this year. As a result, many investors are bracing for a possible recession. However, despite that, economic data still remains positive. So, here’s why a recession might not actually happen, and why I’ll be buying this hybrid growth and defensive stock.
What does the yield curve have to do with a recession?
An economic recession is typically defined as two straight quarters of negative gross domestic product (GDP). This means that the economy is contracting. Many analysts point towards the yield curve inverting as an indicator of an impending economic decline. After all, it has ‘predicted’ seven of the past eight recessions. The yield curve is an indicator of returns from government bonds. These bonds have a maturity date that can range from 1 month to 30 years. Wall Street normally sounds the alarm whenever short-term bonds (2-year) yield a higher return than long-term bonds (10-year), thus inverting the typical yield curve. Investment banks such as Deutsche Bank and Goldman Sachs have even predicted a recession based on this.
Cherry picking
I believe the data surrounding the relationship between the yield curve and an economic recession has been cloudy. Among all the times the yield curve has inverted in the last 30 years, a recession only preceded it three times. As such, I do not believe that three, or even arguably two data points constitutes good statistics. It is worth noting that the 2020 recession was caused by a global pandemic. Going back further, the yield curve had also inverted in 1995, 1996, and 1998, with no recession following. While it is common for a recession to follow after the inversion of a yield curve, it is not absolutely indicative of it.
Current economic data remains healthy and robust. The unemployment rate continues to decline while labour participation heads back to pre-pandemic levels. In addition, PMI numbers continue to expand, and spending patterns continue to show that consumers are in good shape. Most importantly, GDP continues to grow despite high inflation. Therefore, I think the economy is in a strong enough position to absorb the impact of rate hikes by the Fed, although an overly aggressive Fed might spark a recession.
Investing in a safe bet
While I do not know whether a recession will or will not materialise, I do know that Warren Buffett’s investing philosophy has been effective in generating healthy returns over the long term. I will continue to invest in companies with solid fundamentals, strong earnings, and potential for growth. I believe Alphabet checks all these boxes. It has a hybrid nature of being a defensive and growth stock. Its monopoly in the search and advertising space means that although revenue will take a hit, its position in the market is unlikely to get compromised. It also has tremendous earnings potential in an increasingly inelastic service, cloud computing. So whether a recession happens or not, I will continue to invest in companies that have strong fundamentals, such as Alphabet.