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3 Scary Questions on the Global Economy

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Lately I have been answering questions on a topic which seems to be important to many. Sometimes it comes from a client, sometimes from a friend, sometimes from another advisor. That question centers on the state of the U.S. and global economies.

To be more specific, an advisor from a different part of the country sent me an email asking if I thought the yield curve was going to invert. In addition, a few clients and friends have forwarded articles they’ve read regarding the dire outlook for the global financial system. Since this seems to be a fairly prevalent topic I thought I’d attempt to address it.

Will the Yield Curve Invert?

An inverted yield curve is a sign of a slowing economy and is often associated with a recession. The bottom line: I do not believe the yield curve will invert anytime soon. For this to occur, the Federal Reserve would have to raise interest rates at the short end of the yield curve. Without this action, the yield on the 2-year, 5-year, 10-year, etc., would have to fall below the short-term rate of 0.00% to 0.25%. I rather doubt this will happen. In short, there’s just not enough room at the short end of the curve to allow longer maturity yields to breech it. That said, a continued flattening of the yield curve is a high probability, indicating a weak economy. Consider this, if the economy were really strengthening, why would the Fed be maintaining its zero interest rate policy (ZIRP)?

Will the U.S. and Global Economies Fall Off the Cliff?

The U.S. economy began to rebound in 2014, but it was largely due to the oil boom. Because oil prices have declined to such an extent, many or perhaps all of the jobs gained will be lost. Also, with the rising dollar, the profits of U.S. multinational exporters are declining. We’ve seen this drive down the stock price of Microsoft, Caterpillar and a number of other U.S. corporations that derive a great deal of revenue from exports. Because the global economy is also weakening, U.S. exports will be hit especially hard. To summarize this, a stronger dollar makes our exports less competitive (more expensive) and a weaker global economy will reduce the imports of other nations. The combination of these factors is a huge negative.

Overseas, China may have finished building its “faux cities” which, at the moment, appear to lie barren. Also, Japan continues to struggle, and Europe is very close to the edge. In fact, of all the countries in Europe, only five or six have a positive inflation rate. The rest are in deflation. Europe has yet to do anything of great substance to address its debt problem.

More on this topic

What About Falling Oil Prices?

The decline in oil prices has had a beneficial effect on the U.S. consumer, but the negatives may outweigh the positives. For example, many regional banks have made loans to oil producers. When things hit the fan, these banks could see defaults rise, especially if the price of oil remains low or falls further. As oil company profits decline, many will be purged from the industry, causing loan defaults to rise. In fact, a little less than 20% of the high-yield market are loans to energy companies.

This will have a negative spillover effect on other industries such as hotels, restaurants, housing, etc. After all, who wants to build a new restaurant, hotel, or housing complex in an economically depressed area? This should be mostly confined to Texas, Oklahoma and North Dakota, but there may be some systemic risk in other regions.

Conclusion

What do we do when clients ask our opinion? I believe we should be able to articulate a rational economic view to some extent. I may not be good enough to parrot the view handed down from on high (i.e. upper management). This is because many who espouse a certain viewpoint do so with a degree of bias. For example, stock fund managers need a bullish environment to maintain positive fund flows. Corporate CEOs are usually optimistic in support of their stock price. Therefore, we should remove our rose-colored glasses and ask ourselves, “Why do they hold this opinion?” In other words, do they have something to gain? The worst thing is to ignore the facts and blindly accept a thesis with a low probability.

Until next time, thanks for reading!