The Yield Curve as Recession Predictor…

Economists and policy makers are spending a lot of time talking about the yield curve these days. This bond market metric plots the yields investors receive for different maturity bonds. Because they demand more compensation for holding longer-term debt, the yield curve typically slopes upward to the right (see chart below ). On rare occasions, however, the curve inverts and longer-term maturities offer lower yields than shorter-term maturities.

curve pg 4.jpg

So why should we care about a bunch of lines on a graph? The yield curve recently inverted, a development that occurred just prior to 9 of the past 10 economic downturns. The lag time between the yield curve inversion and the actual onset of recession ranged from 8-20 months with an average time of one year. To understand why the yield curve might have predictive powers consider that prevailing interest rates are actually a reflection of millions of investors’ views. When these investors expect the Federal Reserve to lower rates in reaction to a slowing economy, they flood into higher yielding long-term debt. This increased demand drives down long-term yields relative to short-term yields.

Several economists, however, are now suggesting that the outlook may not be as bad as it seems. More specifically, they claim that the increased demand for long-term Treasury debt comes not from investors’ fears of recession but from other recent developments in the bond market. To meet post-crisis regulatory requirements, banks have had to boost their reserves of ultra safe assets like Treasuries. Meanwhile, insurance companies and pension plans looking to reduce funding risk have also soaked up long dated bonds. Finally, the U.S. government may be playing a role. The U.S. Treasury finances most of its growing budget deficit by issuing short-term debt. This increased supply is likely driving up short-term relative to long-term rates.

Before you breathe a sigh of relief, consider the possibility that the yield curve may be less a predictor of recessions than a cause of them. The reasoning here is pretty straightforward. Banks fund their lending activity with short-term borrowings. When these funding costs go above what they can earn on long-term loans, lending dries up and with it general economic activity. Further, businesses may react to yield curve inversions by cutting back capital spending and other investment plans.

While the yield curve’s inversion can’t be viewed as a positive, investors should take a deep breath before running for the exits. First, measures of the “real” economy like unemployment and consumer confidence are holding up pretty nicely and research has shown that when the yield curve is flashing red and the real economy is doing well, it’s best to pay attention to the real economy. Second, economic predictions are notoriously bad (consider that most economists failed to see the global financial crisis coming).

spread pg 4.jpg

Unfortunately, we cannot know with any accuracy when the next recession will hit. But if history holds, when it arrives it will be neither fatal nor permanent. How to prepare? Make sure your current mix of bonds, stocks and cash is in line with your overall tolerance for risk. And don’t forget to hold sufficient cash to cover short-term (3-12 months) spending needs. In a down market, nothing soothes the nerves like cold, hard cash.

5G, Not Just Another Phone Upgrade…

Industry experts expect great things from 5G, the latest generation of wireless technology. To understand why, it helps to know a bit about how cell phones function. Cell phones convert voice and data into electrical signals and then transmit those signals over radio waves to the nearest cell tower. The cell tower then passes the signal along either through physical phone lines or by radio waves to the end destination.

The infrastructure used to transmit and receive signals today, everything from chip sets to antennae, has been designed for lower radio frequencies. Thanks to the explosion of mobile usage, these frequencies are getting saturated. Dino Flore, a Technology VP at Qualcomm, estimates that there are over 8 billion cellular connections today. Without change, the strain on the existing network will cause transmission failures and delays.

China out Front pg 4.jpg

Fortunately, engineers from around the globe have been working together to develop new cellular architecture standards capable of handling the growing network demands. 5G, which transmits data at higher frequencies, is the result of these efforts. In addition to increasing network capacity, 5G also reduces “latency” or the time it takes for devices to respond to each other. When fully deployed a 5G network, for example, will be able to connect 1 million devices per square kilometer, or transfer a full length, high-resolution film in 2 seconds. Industry experts believe this reduced latency will spur significant innovation. In medicine, for example, 5G could improve doctor/patient relations through higher quality video-conferencing and allow remote surgical procedures. Though less revolutionary, gamers could enjoy a more seamless streaming experience.

While promising, a full rollout of 5G will take time. The new network’s technical requirements make widespread adoption particularly expensive and challenging. High frequency signals are more fragile and, as such, require a vast number of close range micro cells and antennae. Technology consulting firm Greensill estimates that 5G related spending could hit $2.7 trillion by 2020. These investments will be challenging for network carriers like Verizon who must figure out how to get consumers to pay for their enhanced service.

China is furthest along in the race to build out a 5G network where firms like Huawei hold a significant share of 5G patents. On the infrastructure side, Deloitte estimates that since 2015, industry leaders Huawei and ZTE have deployed 10 times as many cell sites as we have here in the U.S.

5G pg 4.jpg

The recent move by the U.S. to prevent domestic tech firms from exporting network infrastructure to China on national security grounds highlights how high the stakes are in the race to gain technological advantage. While these trade spats may slow down the pace of 5G adoption, they are unlikely to stop it. Handset manufacturers in both the U.S. and China are already releasing 5G phones albeit with limited range. Denying Huawei chips and other technologies may actually backfire and cause them to speed up efforts to develop homegrown technology solutions.

If history is any guide, I would not dismiss 5G’s potential impact. Ten years ago, 4G’s rollout lead to the rise of whole new businesses like Uber and Airbnb. I would expect this time to be no different.


Technologies That Will Change the World in 2019...

By all accounts we are living in a period of robust technological improvement. Innovations from smart phones to artificial intelligence are fundamentally changing lives and altering the way business is done across a wide range of industries. Historically, technological innovation has been the “secret sauce” that has fueled economic growth and the rising living standards that come along with it. But a strange thing has occurred over the last decade. Since 2007, productivity growth in the U.S. has averaged just 1.3% a year. This rate is less than half the gain recorded from 2000-2007 and well below the 2.1% annual average since 1941.

Economists have been scratching their heads trying to figure out what is behind these weak results. Some, like Martin Feldstein from Harvard, think we simply have a measurement problem. He argues that the way we measure productivity - - generally the amount of goods and services produced per hour worked - - does not capture the value associated with qualitative improvements. Google Maps, for example, does not provide a much different output than physical maps do, but it is a lot easier to use. Others, such as Northwestern University’s Robert Gordon, are less optimistic. He contends that today’s innovations do not have as much of an economic impact as blockbuster innovations of the past, like the electric light bulb. A third group argues that technological innovation occurs in waves. The wave begins with the introduction of a “general purpose” technology such as artificial intelligence. The real economic impact, however, is only felt once it is widely adopted and commercialized.

My guess is that all three of these theories play a part in the recent anemic productivity statistics. Artificial intelligence may not be the next “electric lightbulb” -- Siri dialing a phone number for me is certainly convenient but it is hardly a groundbreaking innovation. But this technology is still in its infancy and may yet prove disruptive in a number of ways.

Each year, the MIT Technology Review prints a list of the technological developments expected to have the most impact on human life. The author of this year’s list is none other than Contributing Editor and Microsoft founder Bill Gates. Mr. Gates’ emphasis this year is in keeping with Martin Feldstein’s more optimistic view of the world. Many of the developments on his list focus on improving the human condition. Just over half involve healthcare. The gut probe in a pill and wearable health monitor, for example, both are aimed at improving patient outcomes, while the self-contained toilet is focused on reducing disease in the developing world. Innovations that focus on cleaning up the environment also feature prominently on the list.

Bill Gates page 1.jpg

Mr. Gates, one of the world’s leading technologists, is optimistic about the future, and his selections reflect that view. While he still thinks that much can be done to extend life, especially in some of the world’s most disadvantaged areas, he believes strongly that new technologies can help enhance personal fulfillment. This shift would represent quite an achievement if viewed from a longer term historical perspective.

Rising Debt Levels Here and Abroad…

While the economic recovery has been slower than many would have liked, it has been fairly broad based and persistent. Investors can thank the expansive fiscal and monetary polices of central banks around the globe for much of the rebound. But unfortunately, the last decade of ever lower interest rates also has fueled a buildup in debt levels. According to the Institute for International Finance (IIF), as of the third quarter of last year, global debt totaled $244 trillion or a near record 318% of GDP. Most of this increase (75%) has come from government and non-financial corporate debt issuers (see chart below). Emerging markets have seen the largest increase in corporate debt while in more mature markets, government issuers fueled the gains. The IIF statistics also reveal a persistent global shift away from traditional bank financing. This has been particularly true in emerging markets where nearly 25% of total credit to the private sector now originates outside traditional channels.

Global page 4.jpg

The rise of non-bank lenders is presenting a particular challenge in China today. Over the last decade, local governments and their more than 2,000 financing companies have funded economic development projects by issuing large amounts of privately offered funds. Independent brokers and advisors, in turn, have offered these investment vehicles to individual investors. But assessing credit quality in this sector of the Chinese bond market is particularly difficult given insufficient oversight and the courts’ limited ability to enforce judgments on governments or state-backed companies. Official data estimates total local and central government debt at just under $4.5 trillion or 36% of GDP. Zhang Ming from the Chinese Academy of Social Sciences further estimates that when all forms of off-balance sheet debt are added in, the total is closer to 67% of GDP.

Provinces in far-off lands are not the only home to debt problems. Consider the case of student debt here in the U.S. The dollar amount of student loans outstanding is not overlarge when compared to other forms of consumer debt. At $1.44 trillion, it is similar to the amount of auto debt outstanding ($1.3 trillion) and well below total mortgage debt ($9.1 trillion). But the increasing delinquency rate of these loans is of real concern. As of the third quarter of 2018, 9.1% of student debt was more than 90 days overdue. Delinquency rates doubled over the 2003-2011 period and a recent study by the Brookings Institute, estimates that almost 40% of borrowers are expected to fall behind by 2023. Loan delinquency in this population of 44 million borrowers is particularly damaging to the economy; student loan borrowers are generally entering their household formation years, a period of above average consumer spending. Student debt also has the potential to negatively impact multiple generations given that many privately issued loans are not discharged at death.

Dangers page 4.jpg

Low interest rates were likely just what was needed to get us out of the 2008-2009 financial crisis. But having elevated debt levels concentrated in specific sectors of the global economy may become a big problem if either economic growth slows or interest rates increase. Central banks around the globe are doing their best to balance the risks associated with these two outcomes.