Are We Heading for Recession?

Holly Black: Welcome to the Morningstar series, "Market Reaction." I'm Holly Black. With me today is Dan Kemp. He's chief investment officer at Morningstar Investment Management. Hello.

Dan Kemp: Hello, Holly.

Black: You're here because we're all talking about the R word at the moment, "recession." Why are we doing that?

Kemp: Well, it's a very good question. And it's somewhat circular, because when we see evidence of the economy slowing down, people naturally extrapolate that into a recession, which, as we know, is a period of negative growth that's not just a blip that normally lasts for six months or more. And we're all taught as investors and as consumers to fear recessions. And partly, that's conditioned by the big recession that we went through in 2008-2009. But it tends to be a story that plays in our emotions and often drives us to make bad decisions.

Black: And the thing that has sparked this is that last week the bond yield curve inverted. Horrible sentence. What does that mean? Why is it important?

Kemp: Well, I'll explain what it means, and it's a real question whether it's important or not, but we'll come on to that. So, what it means is that the price you pay to borrow money over the longer term if you are government is less than the price you pay the interest rate for borrowing over the short term. So, typically, when you lend money as an investor to a government by buying a bond--buying a promise to pay that money back--then the longer you're prepared to lend the money, the higher the interest rate you'll receive. And that makes sense because, of course, over the longer term, the risks are greater, whether it's the risk of inflation, which will eat away the real value of your money, or whether it's just a risk that something will happen to the government and they won't be able to pay it back. And so, the longer you're prepared to lend, the more you expect to receive back. And that's called the yield curve because, typically, it rises in a curvelike shape.

Now, what we've just seen in the U.S. is that the price of 10-year money--so, lending money to the U.S. government for 10 years--is now less than the two-year. And that's seen as significant by many forecasters because, in the past, it's tended to be associated with recessions. But we think investing is a little bit more subtle than just taking these very broad indicators and assuming that they'll be able to tell you what the future holds every time and, more importantly than that, they'll be able to tell you what will happen to asset prices. In reality, there's much more going on. And also, it only inverted for a very short period of time. I think it was two or three days. And so, when we think about an inverted yield curve, we shouldn't really pay it too much attention. We should just think about the overall opportunities for investors. And we would agree, they don't look great at the moment, but it's nothing to do with the yield curve. It's because prices are very high.

Black: The thing that blows my mind is that people will accept those returns. We had in Europe a couple of years ago, people accepting a negative rate of interest. And that is a sign of just how worried people are presumably.

Kemp: Well, that's right that people are concerned about lending money. That's one thing that's going on in markets. The other thing that's going on is that governments over the last decade have forced the price of borrowing lower. And so, by lowering short-term interest rates and by buying in bonds, which is a form of quantitative easing, QE, which people will remember, they are forcing interest rates low. And so, in some ways, forcing people to get a negative interest rate on their savings, either an actual negative interest rate or just a negative real rate, so negative return after we take into account inflation. Well, if you're getting a negative return in the bank, then it's sensible to go and look for a higher return elsewhere. But what that does, of course, is put pressure on these longer-dated rates or even on equity prices. So, the prices of everything rise, the return that you get as an investor falls, and that's why we think it's not a great time to take a lot of risk.

Black: So, lastly, what does this mean for me, not just me, any investor?

Kemp: Well, what it means for investors is very similar to what these normal economic signals mean, which is that you should ignore them generally. And instead of being too focused on the latest piece of economic news or the latest tweets by the President of the United States or whatever else is going on in a very noisy environment, you should really spend your time looking at the value of the assets that you're investing in or finding a great manager or a great financial advisor to help you do that. But focusing on the long term and the return that you can expect, not just on what the latest signal is. What that does is--if we pay too much attention to the signals, it drives us to make short-term poor decisions. So important to focus on the long term.

Black: Thank you so much for your time. And thanks for joining us.