Click Here for Printable Version
The global equity and bond markets remain hostage to the actions of the US Federal Reserve Bank.
This, the US Central Bank, sets the American version of Base Rate, which is then used by all the other major economies as the reference rate for their own interest rate.
If the laws of economics are correct, then the speed and scale of last year’s increase in this key rate should precipitate a global recession. So far it hasn’t. This leaves market participants confused and having to hedge their bets.
“Is it different this time”, often very dangerous words in investment, but the Pandemic has fundamentally changed the global labour market and rising unemployment, a key factor in a recession, simply hasn’t happened.
That doesn’t mean to say that it won’t, at least in some sectors e.g. retail and construction, but generally companies have been hurt by the shortage of experienced workers post Covid and are now hoarding staff.
But the high cost of capital is hitting some sectors, commercial property in particular and that does raise the probability that a recession will arrive soon.
From the market’s perspective it wants a recession.
A recession is the medicine to bring inflation down and thus interest rates as well. There are three “scenarios” in play for markets at present:-
1. We are in a “phony war” with the economy, the interest rate increases were so fast they will take longer to work through the economy than normal, thus the recession will arrive soon.
2. Inflation doesn’t come down as forecast and even ticks up again, the Fed thus has to go even further with interest rates which then finally pushes the Global economy into a harsher recession.
3. We remain in the current, no recession, inflation slowly easing situation. The Fed can then reduce the pace and magnitude of interest rate increases, but big cuts are delayed.
Which one plays out depends on the economic data statistics, most are backward looking i.e. Hard Data. However some, such as the ISM and PMI indicators are based on surveys and are regarded as Soft, as they are forward looking and therefore subjective.
Remember markets want a recession.
Where is the Recession? Soft versus Hard data.
(Source: Morgan Stanley)
These charts from Morgan Stanley do show that the growth data is slowing.
In the first, the Soft forward looking surveys (Blue Line) have been indicating a possible recession since the middle of last year.
What it also shows is that Hard Data, when adjusted for inflation (Yellow Line) has been flat for some time and is just now starting to fall off.
This means that inflation is masking a slowdown and possible recession.
Confusingly, the forward surveys do appear to be getting more optimistic just as the actual economy seems to be slowing?
The second chart seems to confirm a slowdown, with US Industrial Production Growth turning negative for the first time since the 2008/09 Great Financial Crisis and the Pandemic. One data point does not however, represent a trend, and often economic data is subject to later revision.
So we need to be careful of reading too much into this chart at this time. Needless to say, if market participants want a recession, the data remains unclear for now. Nevertheless, as the following chart shows the trend is one of global slowing.
Also, it is important to note, in terms of timescale, we are a long way thorough the slowdown, which supports the historic 18 month Bear market pattern which we have highlighted many times before.
This chart from Merrill, brings together various Hard and Soft data elements together to give an overall pattern of where the global economy is in the cycle.
The shaded areas are past recessions. What this tells us is that we are long past the peak in each of these three indicators and are approaching the levels where we historically have had a recession.
This combination of both Hard and Soft data does increase the probability that the global economy will enter a recession very shortly is high.
Conversely, if it is different this time, it does also tell us we are a long way though the negativity. The Red Leading Indicator, could be down to a buying level by the middle of the year.
Remember markets go up when a recession finally arrives.
The Crucial US Housing Market
This chart shows the US housing market compared to other recessions.
Clearly, the big collapse of 2008/09 (Green Line) was caused by the collapse of the US Banking system and widespread mortgage foreclosures. We are not facing a Credit Crunch now, this is a deliberately enforced economic slowdown, it is not a banking crisis.
The collapse of Existing Home Sales is dramatic, but also exactly what should be expected when US mortgage rates are 5.7% for a 15 year fixed rate and 6.5% for a 30 year one.
Buyers are on strike.
There are increasing signs of defaults in US Commercial Property where borrowings are shorter and rates floating. But yet again we see a pattern that this period of declining sales volumes is getting to be “long in the tooth” and thus closer to the turning point.
Markets
The “Goldilocks Scenario” for markets is for inflation to keep falling to c2.5%-3.0% and there is an economic slowdown, but no recession.
This would allow the Fed to claim victory and thus allow interest rates to fall back to long term normal i.e. 3.0% to 3.5%.
Just recently though, the trend of good inflation news has turned more negative. Market expectations have thus changed from US interest rates peaking at 5.25% to 5.75% and crucially not starting to decline this year.
However, this forecast, if correct, would give Joe Biden a problem.
He wants the US economy accelerating by Thanksgiving (November) this year, there is an election coming.
The Fed therefore needs a recession and soon. Theoretically, the sheer scale of the monetary tightening should by now be showing up in the stats, but modern monetary theories have never been tested in a post-pandemic world.
The Spanish Flu of 1918/19 was way before Central Banks started to “manage” economies. That means any one of the three scenarios outlined in first paragraph are valid.
But, the Hard and Soft data do all point to an economic recession appearing very shortly, with recent US Commercial Property loan defaults being perhaps the first sign?
This would not be a bad thing, it’s what the markets want.
Why? It gives clarity (markets hate uncertainty) it allows them to price in the point at which interest rates peak and thus when the recovery will begin.
The danger is the Fed loses patience and tightens monetary policy even further just at the wrong time. As long as inflation starts to tick down again and economic activity slows from here, then markets should be pleased.
If the global economy continues to accelerate from here (against all the indicators) then markets will be very confused and will have to reprice accordingly. It’s all about the economic statistics and inflation numbers, markets will move depending on how good (which is bad) or not they are.
March 2023
Click Here for Printable Version
This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
