Recap & Outlook: European issues remain, inversion

Michael Rudd, CFA | President, CEO and Portfolio Manager

The US and China are the two largest economies in the world. The European Union (EU), as a block, is also a big participant in the global economy (essentially equal to China). The three grouped together account for 65% of global gross domestic product. We wrote about the US and China in the past two Outlook issues so today we write about the EU. In addition, last week the US yield curve inverted. This is a concern for investors and resulted in volatility in North American markets on Friday and overseas into the opening session this week.

  • Regular readers of our Outlook will remember that we have been less constructive about Europe for some time. There are some structural issues in Europe that have given us caution for some time. National debt levels and deflation have been well reported on over the years. More recently, Germany, France and Italy have posted flat GDP numbers, 0.6%, 0.9% and 0.3% respectively. This puts the three largest economies (65% of EU) very close to technical recession. With Brexit concerns and other geopolitical issues, we remain concerned. Consequently, we have very little exposure to Europe in our portfolios and expect to remain this way for some time.
  • Figure 1 presents US recession and government bond data. Without getting too technical, over time, when the interest paid on short-term bonds is higher than long-term bonds, a recession usually results within 6 months’ time. The blue line is the difference between the yield on 10-year and 2-year bonds, while the green is the difference between 10-year bonds and 3-month bills. The grey bars are US recessions. As you can see, we have approached the zone where, historically, we would be concerned. This past Friday, the green line has turned negative (first time in 12 years) and remains there Monday morning as we write this note. Based on history, this would imply a recession is coming.

“This means that” we will continue to remain underweight in Europe. It would take substantial improvement in the EU economic and political situation over the medium term for us to evolve our investment thesis. We are also following the US bond market data closely and we expect that there could be some financial market volatility from this development. Previously, we had noted that we did not see data that justified recession concern in the US but this is a new development, which we will discuss intensely at our next Investment Committee meeting.

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