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A US recession is probably coming so investors should just deal with it

Brian Sozzi
Editor-at-Large

You — yes, you the investor reading this — have nobody to blame but yourself if you lose your shirt ahead of what looks to be a mild U.S. recession that starts later this year and carries over into the first half of 2020.

So, plan now (remember, stocks will trade off in front of negative economic growth...), bite all your nails off later when the market headlines get next level ugly and you want to wade into the carnage.

That’s because hands down, recession talk has completely taken over the discussion on Wall Street primarily on escalating U.S. trade tensions with China. It’s so top of mind — in the face of solid, but slowing job gains and easier Federal Reserve policy — it has become commonplace even when economic data is grand. The logic is simple to grasp: U.S. consumers won’t be able to handle tariff-related price increases, while mega corporations delay capital investment due to the high levels of fiscal uncertainty.

Indeed a terrible situation.

And despite fresh assertions from Trumpers such as Peter Navarro and Larry Kudlow, the concerns beginning to grip global markets do appear justified.

The yield curve inverted

Take the currently inverted yield curve — an indication of heightened nervousness in risk markets — for example.

The yield curve inverted on August 14, sending equity markets around the world into a tizzy. Inversions of the yield curve lead U.S. recessions by 17 months, on average, points out BMO Capital Markets Analyst Brian Belski.

“Financial variables are driving upside in recessionary probability model, which now stands at 38%. The slope of the yield curve has been the most important driver,” Morgan Stanley economist Ellen Zenter writes. Encouraging, but not really.

So, there is that flight to safety in U.S. bond markets, but also the one taking place overseas.

About 30% of the global tradable bond universe were negative yielding last week, a record, according to data crunched from JPMorgan.

Tracking bond markets not your thing? OK, well, how about equities that are usually important economic bellwethers. The small-cap Russell 2000 (^RUT) index has dropped 3.9% in the past six months, worse than the 5% gain on the S&P 500 (^GSPC) and 1.1% rise for the Dow Jones Industrial Average (^DJI).

Other bearish clues

(Frank van Manen/The United States Geological Survey via AP)

It’s the smaller cap companies housed inside the Russell 2000 (^RUT) that so often gives strong clues on the real health of the U.S. economy.

“Since the Russell has been an excellent leading indicator for the rest of the market over the years (including last year), any further breakdown in this index will be bearish for the entire market,” says Miller Tabak strategist Matt Maley.

Tough.

Maley calls out the ongoing underperformance of the Dow Jones Transportation Average (^DJT) (down 5% the last six months) as another bearish signal on the U.S. economy.

While investors are dumping forward-looking parts of the equities markets (and loading up on low yielding Treasuries), they continue to voice their concerns in metals. Gold prices have rallied some 20% since the end of May. Copper — a metal vital in capital equipment — has seen its price plunge 12% going back to early April.

Don’t trust real-time asset markets? Corporate commentary hasn’t been too hot in recent weeks either. One top hotel executive tells me some key partners have taken a pause in remodeling their properties. Retailers Macy’s (M) and Tapestry (TPR) have called attention to weak tourist-related spending at top flagship and outlet locations (mostly Asian travelers).

“Looking ahead to the rest of the crop season, trade uncertainty continues to dampen sentiment across the U.S. farm economy,” Deere & Co.’s (DE) Chief Economist Luke Chandler told analysts on a December 16 earnings call.

The impact of that: Most farmers Yahoo Finance has talked with aren’t thinking about investing in the pricey equipment being sold by Deere unless something breaks.

Again, not encouraging.

A 10%-15% correction ahead

These are but a few of the realities out there that counter those perma-bulls banking on the U.S. consumer to save the day. A bruising U.S. recession is unlikely due to good labor market conditions and consumer savings levels, but two quarters of very slightly negative data (technically, this would be a recession) seems more than possible.

And the downside risk to markets against the backdrop of a mild U.S. recession? Possibly sizable, though not as brutal as the Fed policy mistake rout in equities that occurred last December.

“We believe the views of too many people are too extreme right now. However, we DO think that the odds are high that we will see a 10%-15% correction (that could overshoot even further) going forward,” Maley says. “The risk/reward equation has changed significantly over the last month…and therefore we believe investors should raise cash on the kind of bounces we saw on Friday…so that they can take advantage of the next time investors throw the baby out with the bathwater (like they did in Q4 of last year).”

Don’t say you haven’t been warned.

Brian Sozzi is an editor-at-large and co-host of The First Trade at Yahoo Finance. Follow him on Twitter @BrianSozzi

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