A few weeks ago I wrote an article called ‘What could possibly go right’? My main point was that equity markets were being over-optimistic against the near certainty of a recession. I thought that analysts, especially those too young to have known markets before the 2008-2009 Global Financial Crisis, were perhaps being naïve about the impact of an economic slow-down on corporate earnings.
Markets and economies have responded to renewed QE
I still believe that markets are too gung-ho. However, Armageddon has been avoided, or at least postponed. Central banks continue to raise rates but are taking the harsh edge off this by boosting their balance sheets at the same time. The People’s Bank of China in particular has turned to a much looser policy, adding US$ 440bn to their balance sheet in the last two months alone. I assume this has been to counter the impact of their late lock-downs on both the economy and domestic public opinion.
The result has been a better outlook for global economic growth. Indicators such as corporate bond spreads, shipping rates, and cyclical stocks are all pointing in the right direction. The latest forecasts by the IMF suggest that global growth in 2023 will be 2.2%, a rise of 0.2%. This is still a very low number, but much better than a negative one. Only the U.K., subject to its own peculiar mixture of toxic factors, is now expected to go into a recession.
Inflation is forecast to fall to 2% by end 2024
At the same time, most forecasters confidently expect inflation to fall back sharply. The IMF has pencilled in 2.6% for 2024 compared to 7.3% in 2022, the Bank of England suggests even in the U.K. inflation will be below 2% by the end of 2024, and bond market investors have a break-even rate of around 3%.
In some ways, given the geo-political stresses around China and Russia, this is about as benign a scenario as we could have imagined six months ago. Even the U.S. fourth quarter earnings season, although declining slightly, was better than expectations, and 2022 earnings were about 4% higher than the previous year. So perhaps I should not be surprised that equities have risen over the past three months, and FTSE briefly reached a new all-time high last week.
U.S. yield curve is more inverted than three months ago
However, not all is rosy. I start by examining why the Federal Reserve is on the one hand raising interest rates, and on the other expanding its balance sheet. On the face of it these are inconsistent policies, one tightening and one loosening monetary policy. The explanation lies in my view once again in the fragility of short-term corporate borrowing markets such as the reverse repo markets.
I have written about these before, but the salient point is that reverse repos require ‘safe’ collateral, which has traditionally been in the form of government bonds. Demand from this source is one of the factors behind the low bond yield environment of the last twenty-five years – yes, even before the Global Financial crisis.
The evidence for this is in an extraordinary chart from our friends at CrossBorder Capital. It shows the U.S. T-bond term premia (i.e., investor’s willingness to invest for a longer period) at the 10-year tenor, adjusted for inflation and volatility. At around -2% the term premium today is at the lowest level it has been in over 60 years except briefly in the late 1970s at the end of the Carter regime. A major cause is the insatiable demand for collateral by reverse repo markets.
CrossBorder’s analysis shows that term premia have a much larger impact on bond prices at the longer end of the yield curve. This may be a partial explanation for the second elephant in the room: the U.S. bond yield curve is more inverted today (around 80bps) than it was three months ago (33bps). Normally, this would be a reliable indication of an economic slowdown ahead, and my pessimism would be entirely justified.
There is no ‘good’ explanation for the inversion
Today an alternative explanation lies with the reverse repo markets, as I have described above. But whatever lies behind the yield curve inversion, whether demand from short-term borrowers needing safe asset collateral or investors taking risk off the table ahead of a recession, it is not good news. Either the financial system or the economic future is fragile.
Investors may take their choice of explanation, but either way in my view equity markets are still being far too sanguine. Bulls may point to the current U.S. Price to Earnings ratio at about 17x. It is lower than the recent past, but still significantly higher than the long-term average of around 14x. I suspect there may be an element of markets – as they like to – trying to make life as uncomfortable as they can for as many investors as possible. Right now, that includes me. However, it does not shake my conviction that the next major move in equity markets will be downwards, not upwards.