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Inside the Market Forget recession. The real challenge for investors now is slow growth

A growing number of people are beginning to think about what was once considered unthinkable – the prospect of zero, or even negative, interest rates in the world’s largest economy.

Alan Greenspan, the former chairman of the U.S. Federal Reserve, said last week it is only a matter of time before the sub-zero rates in Europe and Japan spread to the United States. Jamie Dimon, chief executive of JPMorgan Chase & Co., the biggest U.S. bank, told an investment conference on Tuesday his company is already analyzing how to deal with zero interest rates, on the remote chance they do arrive.

Then on Wednesday, U.S. President Donald Trump added his two (negative) cents, using his Twitter pulpit to urge the “boneheads” at the Federal Reserve to cut interest rates to “zero, or less.”

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What should investors make of this chatter? If zero rates, or negative rates, do come to pass, the big winners would be bondholders, since the price of bonds goes up as rates fall.

The problem with this investing thesis is that it is by no means certain rates will fall much from here, no matter what Mr. Trump tweets. While falling interest rates and recessionary fears were the overriding market themes in August, sentiment has shifted in September. It now appears that those betting on big rate cuts may have gotten a bit ahead of themselves.

Investors spent August rushing into the supposed haven of bonds because of spiralling fear about a slowing global economy and a potential U.S.-China trade war. One key indicator, the difference between yields on two-year and 10-year Treasury bonds, inverted its typical pattern late in the month. This is usually a reliable sign of a U.S. recession ahead.

But the latest economic news doesn’t suggest a recession is imminent. The jobs markets in Canada and the United States continue to chug along, with unemployment levels hovering around half-century lows. Canadian home starts have bounced back; U.S. retail sales are holding up well. Factories around the world are struggling under the threat of a trade war, but the much larger services sector is still soldiering ahead, according to surveys of purchasing managers.

So much for apocalypse now. Bond yields have crept upward in recent days as investors emerge from their bunkers. North American stock-market indexes are holding near record highs. And the inversion in the spread between 10-year and two-year Treasuries has ended.

The market’s sudden change of heart doesn’t mean everything is peachy, but does suggest that maybe, just maybe, investors had grown too obsessed with the possibility of a sudden 2008-style crash.

“None of the usual causes of recession appear to be lurking on the horizon in the world’s major advanced economies,” Neil Shearing, group chief economist at Capital Economics, wrote in a note this week. Rather than an outright recession, he said, “the bigger threat is a prolonged period of low growth and low inflation.”

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Analysts at Citigroup have a similar viewpoint. “Our base case has been for a sustained period of global economic stagnation,” Jeremy Hale wrote. His team argues that more rate-cutting by central banks will continue to support stocks, while the tariff war between the United States and China continues to cast a pall over world trade. Over all, the Citigroup researchers recommend holding slightly less in stocks than normal, but they aren’t running for the hills.

Their lack of panic reflects, in part, the lack of obvious havens. Bonds are the traditional refuge for nervous investors, but the recent fall in bond yields means many bond investors are now locking in a loss if they hold bonds to maturity.

In comparison, stocks – especially ones with good dividend yields – look rather tempting. In Canada, the United States and most other advanced economies, major stock indexes now pay out more in dividends than government bonds offer in interest payments. Why settle for a measly 1.4 per cent in interest from a 10-year Government of Canada bond, when you can buy an index fund that tracks the S&P/TSX Composite Index and get double that payout in dividends?

Bonds still make sense if you believe central banks will aggressively cut interest rates to spur flagging growth or if you are convinced a recession lies directly ahead. However, neither possibility seems as likely as it did a month ago.

The trade tensions between the U.S. and China remain a major cause of worry, but the announcement earlier this month that the two sides would resume face-to-face talks in October has offered hope the two countries may yet strike a deal.

Meanwhile, the recent flurry of decent economic data has dimmed expectations for a big rate cut at the Fed’s meeting on Sept. 17 and 18. Markets had once hoped for a cut of half a percentage point. Now, a quarter-percentage-cut seems far more likely. In addition, the futures market is now predicting less than a 50-per-cent chance of a rate cut by the Bank of Canada before mid-2020.

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Some commentators are sounding more optimistic – at least, if you define an optimist as someone who doesn’t expect an imminent recession.

Mr. Shearing at Capital Economics argues that recessions usually have one of six causes: central banks raising interest rates, governments cutting spending, the bursting of a debt bubble, the bursting of a housing bubble, a balance-of-payments crisis or a banking crisis. None of those factors are ringing alarm bells right now, he says. Central banks are cutting rates, governments appear prepared to spend more, and it’s hard to spot an obvious bubble that could crash the global economy.

In the United States, the most likely scenario is a slowdown, not a recession, according to Dean Baker, senior economist at the Center for Economic and Policy Research in Washington. The U.S. economy has evolved away from sectors, such as home building and auto production, that are prone to big swings, he noted in a recent analysis. It now depends more on areas, such as medical services, that don’t gyrate with the business cycle.

Growth will slow as a result of trade tensions and the fading impact of Trump tax cuts, but “there is not an obvious recession story on the horizon,” Mr. Baker wrote.

So, what is an investor to do in this scenario? A slowing economy would be bad news for the frothiest sectors of the stock market. However, it would be neutral to good for bonds even if rates don’t head to zero. In this uncertain environment, tilting your portfolio toward bonds and defensive, dividend-paying stocks isn’t exactly an exciting strategy, but it makes more sense than the alternatives.

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