Four Common Questions Investors Have About Our Economic Outlook

Dave Donabedian, CFA
August 21, 2019

Chief Investment Officer Dave Donabedian fields questions about recent economic developments, including the inverted yield curve and the trade war with China.
  1. What’s behind the selloff in equities and rally in bonds?

We believe the perceived rising risk of recession is based on the following recent events:

  • August 1 U.S. announcement of additional tariffs on $300 billion of Chinese goods
  • Chinese response of weakening the yuan and further potential retaliation
  • Very weak economic data from Europe, and softer Chinese data
  • Deeper inversion of the Treasury yield curve
  • Sluggish Q2 S&P 500 earnings results and downward revisions to the second half
  1. Has CIBC Private Wealth changed its position on the economic outlook as a result?

No. Our base case remains that the U.S. economic expansion will likely continue for several more quarters, albeit at a slower pace. America is a consumer driven economy (70% of gross domestic product or GDP, according to Bloomberg), and the consumer is in good shape (low unemployment, decent wage growth, low borrowing rates and high confidence readings). This was reinforced by Thursday’s retail sales report. While the industrial side of the economy is soft, there are signs of bottoming in recent data. Overall, economic stats have started to exceed admittedly low expectations.

U.S. Citigroup Economic Surprise Index

U.S. Citigroup Economic Surprise Index
Source: Strategas, as of 08.16.2019.

We are by no means ignoring the events previously listed, but in our view, it adds up to mediocre growth rather than recession. The fact that the Federal Reserve Bank (Fed) is likely to lower policy rates by an additional 50-75 basis points in the months ahead—and that other central banks are headed toward more extraordinary forms of monetary accommodation—also argues for an extended growth cycle.

  1. Isn’t an inverted yield curve a good predictor of recession?

We believe an inverted yield curve has usually been a good predictor of recessions, but it is currently distorted by the Fed’s $2 trillion holdings in U.S. Treasuries and the increase in supply of short-term Treasuries required to fund the large U.S. budget deficit. Also, the nearly $17 trillion in sovereign debt carrying negative yields may also be distorting the shape of the yield curve by suppressing longer-term yields.

Normally, the yield curve does send important market signals, and an inversion could sway investor sentiment given its prior record as a leading indicator. We are not dismissing the yield curve, but we believe relying on a single factor to predict something as complicated as the U.S. economy is misguided. As the gold line in the chart below indicates, an inverted curve typically signals a high likelihood of recession 12 to 18 months out. However, the distortions mentioned above lead us to seek out a more thorough analysis.

We believe a more comprehensive approach is to weigh a number of important factors including, but not limited to, the yield curve. Our Asset Allocation Committee tracks a proprietary indicator of economic and financial market conditions that incorporates the yield curve, credit spreads, purchasing manager surveys, profitability, the dollar and other leading economic indicators. As seen in the gray line below, it indicates a significantly lower recession risk than the yield curve itself and is well below where it stood leading into prior recessions. Nevertheless, it has risen in recent weeks, and we are tracking it closely.

Leading Indicators of U.S. Recession

Leading Indicators of U.S. Recession
Our Asset Allocation Committee tracks a proprietary indicator of economic and financial market conditions that incorporates the yield curve, credit spreads, purchasing manager surveys, profitability, the dollar and other leading economic indicators.

4. What is the outlook for the trade war with China?

In the most recent Financial Markets Monitor, we identified this issue as the single biggest risk to the outlook for the economy and equities: “The U.S.-China trade dispute remains a major geopolitical variable that is likely to impact market sentiment in the weeks ahead.” The situation has deteriorated in recent weeks, so the resulting market volatility is not surprising.

The Trump Administration’s plan to impose 10% tariffs on the remainder of Chinese imports (some in September, some in December) is a clear escalation of the conflict. China’s immediate response—to allow its currency to deflate—raises the risk of back-and-forth escalation that would be economically self-destructive to both economies. In our view, this scenario represents the biggest recession risk. At the moment, both sides are hunkering down, creating uncertainty about the path forward. This is largely responsible for the negative sentiment that has taken hold in the equity markets, and the flight to safety that has submerged bond yields.

It is nearly impossible to predict the short-term twists and turns in this trade dispute. We may well see more saber rattling in the days and weeks ahead. The consensus view of the long-term outcome seems to have become more pessimistic as many analysts appear to be adjusting their expectations on a trade deal to beyond the 2020 U.S. election. The rationale is that China has the policy tools to deal with the fallout while it waits for a possible new U.S. administration to deal with in 2021.

We would rate the odds of a trade deal—or at least a truce—prior to the 2020 election as fairly high. The impending tariffs will fall mainly on consumer goods, creating some combination of higher costs on households and lower margins for U.S. businesses. These are not trends that make voters happy. Further, the U.S. farm economy—a key part of President Trump’s base—is faltering.

From the Chinese perspective, the trade dispute has already taken a toll on its economy and disrupted the government’s economic reform plans. China is losing business to other emerging economies as multi-national companies diversify their supply chains. There is also great risk to China using its currency as a weapon in the trade war, as it could prompt substantial capital flight. Already, inward investment into China has come to a virtual standstill.

In short, we think the political pressure will grow to take a more pragmatic approach and declare victory by reaching some kind of agreement well before the election.


1   Bloomberg, as of 08.16.2019.

CIBC Private Wealth Management includes CIBC National Trust Company (a limited-purpose national trust company), CIBC Delaware Trust Company (a Delaware limited-purpose trust company), CIBC Private Wealth Advisors, Inc. (a registered investment adviser)—all of which are wholly owned subsidiaries of CIBC Private Wealth Group, LLC—and the private wealth division of CIBC Bank USA. All of these entities are wholly owned subsidiaries of Canadian Imperial Bank of Commerce.

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