It is only two months since I last wrote about markets. I thought then that recession was odds-on and looked at some of the strategies investors might adopt, including investing in government bonds. I make no apology for returning to the subject, but I am going to focus this week more on what a recession might look like and less on what investors might do.
A recession is now almost inevitable
I will start by repeating my main point last time: in my view recession is now baked in unless there is a sharp volte-face by the Federal Reserve. In fact, it is probably already here, even if not yet confirmed by backward-looking GDP data.
The evidence today is everywhere: business confidence surveys and purchasing manager surveys such as Markit are collapsing; commodity prices are falling; and the US yield curve is flat from 2 years out to 30 years. Regular readers will not be surprised to hear that our friends at CrossBorder’s overall liquidity numbers at 29.5 (range 0-100) are plunging and sending a clear message that recession looms. Their central bank liquidity index stands at 15.9, and their diffusion index indicates that no central banks are easing (though see my comments on China below).
Those still arguing for a soft landing are pointing to full employment and some recovery in entertainment and housing prices. But full employment seems to be because whole segments, both near retirees and the young, are choosing to withdraw from the employment market. And housing prices are perhaps benefitting from the difficulties of spending money on holidays or lack of attractive financial assets to invest in. I do not believe they are a sign of things improving.
Brace for more tightening from the Fed.
On the contrary, given the Federal Reserve’s stated determination to thump inflation on the head, we should all be braced for things to get worse. The Fed. cannot control what happens to energy or food prices globally, nor can it raise interest rates as much as it would like because of the pressure on borrowers. But it is concerned with the persistence of inflation, which is now roughly halfway between peak stickiness in 1978-9 and the average during the benign conditions in recent years.
So, the Fed.’s tightening tactics seem to be to withdraw dollars from the market. According to CrossBorder’s calculations, it has already withdrawn around US$ 1 trillion, and is planning to remove a further US$ 1 to 2 trillion. If they go ahead, CrossBorder calculate this would be equivalent to an interest rate tightening of 4 to 5%, much tighter policy than investors today believe to be the case.
Note that according to CrossBorder data the Fed.’s stance at end June was less tight than most other central banks. In my view the explanation for this lies deeply buried in the repo markets. If U.S. money market funds and short-term borrowers turn to the reverse repo market, demand for ‘safe asset’ collateral to collateralise these transactions could suck liquidity out of the system in an uncontrolled fashion, as happened in 2008/9 and nearly in 2018. The Fed is aware that this has the potential to precipitate the hardest of landings and is therefore acting more circumspectly with the levers which it can control.
Possible reasons to be more optimistic
There may be some counterbalance from China, which now accounts for 31% of global liquidity, and whose actions are just as important as the Fed.’s for global investors. The People’s Bank of China (PBOC) has been tightening in line with the Fed. over the last six months. As I have discussed before, in my view their primary ambition is now stability over all-out growth, and they do not wish to risk the yuan’s role as a trade currency. However, partly because of their renewed COVID lockdowns, the Chinese economic engine is sputtering, and there is talk of an infrastructure spending stimulus. For global investors, the question is whether this local spending feeds through to the global ecosystem.
It is also possible that there may be an economic boost in consequence of the war in Ukraine. Economies on both sides of the divide are having to spend to adjust their supply systems to deal with a new less globalised world. There may also be some direct spending to replenish resources used in the war. For example, inventories of weapons in the West were at low levels, and those offered to Ukraine will need to be replenished.
Hard landing ahoy!
Putting all this together, I can only see a hard economic landing coming. The underlying cause is likely to be the Fed. resuming tightening, whether by raising interest rates or withdrawing US$. If bond yield curves invert, as I expect, that may focus investors’ attention on the economic issues. Equally, a surge into reverse repos could put pressure on short term money rates and thence the financial system, much as in 2008-9.
No recession or financial crisis is exactly like the previous one. I expect the next one to be more like a traditional recession (e.g.1990-1992), but that is primarily because I do not expect the authorities to come to the rescue of investors or companies unless the financial system is endangered. That is very different from the last 25 years, when their response to any significant problem has been quantitative easing.
Equities are most vulnerable
There is therefore likely to be more pain to come from companies defaulting. Equity investors are lower down the corporate hierarchy, and more at risk. Yet the S&P 500 is trading at an earnings yield of around 5%, almost the same level as the redemption yield on BBB (i.e. the low end of investment grade) corporate bonds. (In contrast, non-investment grade CCC bond yields have ballooned out to 14.7% reflecting their risk). When analysts adjust down their earnings estimates, the earnings yield will rise unless stock prices fall. I do not think that is remotely sustainable and is why I fully expect equities to have another leg down.
If I am wrong, it will be because the U.S. index is still tech heavy, and tech earnings in aggregate will continue to grow, simply because the role of tech in the world’s economy. However, investors in any company which is vulnerable because its business model has become outdated, or which is overly leveraged, should beware.
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