Commodities and commodity stocks have had a great run this year as investors reach for the 1970s playbook in search of hedges against global tension and domestic inflation alike. That’s why it’s a little shocking to see them selling off this week.
The carnage is real. Oil is down 7% since Friday’s close and both copper and gold have retreated as well, taking major mining stocks down with them.
Part of this is rooted in hope that peace talks will actually get Russian troops out of Ukraine and bring the region’s raw materials back to the global market. I don’t find this theory convincing, but we still have to recognize the chatter in the background.
What’s more serious is the scenario where commodity prices are softening because demand is being destroyed. If so, that’s a recessionary signal . . . and more people on Wall Street have started talking about recession in the last few weeks.
Suddenly everyone is watching the yield curve and feeling like an expert in its theoretical power to predict economic downturns. We’re told every day that various segments of the curve have flattened or inverted, bringing that theoretical recession closer with every twist in interest rates.
Sure, the current interest rate environment points to a recession ahead. But that doesn’t mean what a lot of people think.
There’s always a recession ahead. The economy is cyclical. It passes through expansive phases and periodic contractions.
On average, we’re never more than 5-6 years from the next contraction. Since the current expansion officially started almost two years ago, a normal cycle implies a recession is likely before 2025 or 2026.
That’s practically a lifetime on Wall Street. In 3-4 years, investors can make a lot of money and then ride out the rough season in good enough shape to do it again.
And the expansions are both longer and more intense than the contractions. The economy keeps getting bigger from cycle to cycle . . . not smaller. Over a long enough time frame, stocks go up.
That’s true no matter what the yield curve looks like. Someone who dumped the S&P 500 in 2019 when the curve fully inverted cheated themselves out of an 18% gain in the next six months. Add another two years and the market as a whole is up 60%, despite the intervening pandemic and the most savage recession in recent memory.
Furthermore, while parts of the curve are distorted, we’re a long way from the clear signal that 2019 flashed. At present, some short-term rates have gotten ahead of their longer-term counterparts, but the curve as a whole looks less upside down than simply flat.
A flat yield curve means there isn’t a lot of difference between long- and short-term interest rates. That’s about what you’d expect in a world where the Fed is raising the short end of the curve with every tightening move.
In fact, the curve looks a lot like it did back in 2017, three full years from the COVID recession. (And who knows how the economy would have evolved if the pandemic hadn’t struck?)
If you ran from the curve then, you would have missed the chance to double your money in the S&P 500 over the intervening five years. That’s a better-than-average return.
St. Louis Fed President James Bullard did the research back in 2017 and noted that the curve started flattening out three years previous. Ultimately, he concluded, the effect came from the Fed’s shift out of the post-2008 zero-rate posture raising the short end while long-term rates were relatively stable, compressing the spread in the middle.
Those stable long-term rates were a factor of abnormally low inflation, Bullard said. In that case, people who are stuck with the 2014-19 playbook are going to have an unpleasant surprise this time around.
I think that outdated playbook is why long-term rates remain historically too low to support a “normal” yield curve. And the unpleasant surprise is playing out even as you read this, in the form of the ugliest Treasury market in decades.
Either way, people who say they’re afraid of the curve now would have walked away from stocks in 2014 . . . if they were paying the same kind of attention they are now. Maybe they did.
But somebody was buying stocks throughout the last decade and booking solid returns. That’s where I was, fighting the yield curve every trading day.
Wall Street’s forecasters collectively say there’s maybe a 1-in-3 chance of a recession between now and the end of 2023. Before the Ukraine invasion, those odds were roughly half what they are today.
And the odds favor continued expansion into 2024 and beyond, at which point the post-COVID economy will be well established. Beyond that point, who knows? Recessions are inevitable.
They cause a lot of pain but also ultimately generate a lot of wealth. The destruction is painful but fleeting. The disruptive opportunities are more persistent.
You can’t invest if you’re always looking over your shoulder. And as the Fed learns to manage the cycle, the expansions get longer while the contractions get less frequent.
The last recession was measured in weeks. The last boom ran over a decade. We can accept a few weeks of rain in order to chase those sunny decades.