Is the North American economy heading for a recession?

The Dow Jones Industrial Average, one of the main stock indexes in the U.S., experienced its worst day of the year on Monday dropping by 760 points or 2.9 per cent.  After such a dramatic drop, many investors wonder: is is a recession or bear market coming?

Before answering this question, I thought I would explain what caused the 760-point drop. Last week, U.S. President Donald Trump announced a new 10 per cent tariff on certain goods that the U.S. buys from China. In response China has allowed its currency, the yuan, to depreciate against the dollar.

When the US imposes a new 10 per cent tariff against China, it essentially raises the costs of Chinese goods by 10 per cent. However, by China allowing its currency to devalue by 10 per cent, it negates the impact of the U.S. tariffs.

Historically, China has pegged its currency to the U.S. dollar. Now, that is no longer the case so global markets reacted negatively. This is why the Dow experienced the dramatic price drop on Monday.

Since then, the Dow has rebounded and much of Monday's losses have been erased.

Is a recession or a bear market coming?

Recessions and bear markets are inevitable (as are recoveries and bull markets) so there is always one on the way.

 A better question might be: what conditions cause a recession and are those conditions present in the current economic environment?

The last 11 recessions were caused by one of three events: a spike in commodity prices, the U.S. Federal Reserve (Fed) aggressively raising interest rates or excessively high stock prices. Currently, commodity prices are range bound which means they are not spiking. The Fed is lowering, not raising interest rates.

The stock market valuation of the S&P 500, Wall Street's benchmark stock index, is trading at a 25-year average of 16 times price/earnings; this indicates that the market is neither cheap nor expensive. So that's the good news, based on historical data, a recession in North America doesn't appear to be imminent.

But then there is the inverted yield curve, while not a perfect predictor of a recession, it has a solid predictive track record. Inverted yield curve occurs when long term interest rates are lower than short term interest rates. This usually only happens if investors believe that economic growth is likely to slow.

Over the past six decades, whenever the yield curve inverted and stayed inverted for at least 3 months, the economy entered a recession a year or two later.

The yield curve is currently inverted and has been since March.

While recessions are inevitable as they are part of a normal market cycle, I do not believe we will experience one until after the U.S. presidential race.

Elections bolster economy

Historically, elections years are favourable for the stock market. Over the past 21 elections, there has only been three years where the S&P 500 had negative returns.

The last thing Trump wants during an election year is a struggling economy.  As such, his government will be quick to implement strategies to stimulate the economy and stave off a recession. It is also in his interest to get a trade deal done with China as he will want to bolster his image as a "great deal maker" and take credit for growing the global economy.

My "crystal ball" prediction is that we won't see a recession until 2021 or later.

It is a guess and I reserve the right the change my prediction as new information comes to light. For now I'm basing my decision on the current economic data and the predictive power of the inverted yield curve.  

This column is part of CBC's Opinion section. For more information about this section, please read this editor's blog and our FAQ.