Investing into a recession – peering round two corners | Linchpin
A global recession is now odds on
It is almost a year since I suggested markets were close to a top and that economies would follow them downwards. There is no need to comment on the obvious falls in markets – the S&P is down 17% since the end 2021 high, and over 50% of NASDAQ stocks have fallen more than 50%.
The commentariat now predicts a recession on the back of negative U.S. 1st quarter growth and an inverted or flat yield curve. Funding liquidity analysis by our friends at CrossBorder Capital firmly points in the same direction, with overall levels now well below 50% and falling. As always, they watch what is happening in China as closely as the U.S., as policy there has a greater impact on the industrial world, albeit not the financial one.
Chinese policy is tight, presumably to support the yuan at a time when the Japanese yen has weakened considerably. The Bank of Japan has reaffirmed its commitment to a 25bp yield level for Japanese 10-year bonds, and by doing that opened up a negative spread of nearly 300bps against the U.S. It is no surprise that the currency has fallen despite its usual sage haven status. But the Chinese authorities do not wish to follow suit.
This all suggests that the economic downswing is well under way but leaves investors with some big questions. How deep will the recession be? How much have equity markets already discounted? Are government or investment grade corporate bonds worth buying again now? Can real estate or other real assets mitigate the effects of inflation in a recession? Does the value of the optionality which cash offers outweigh the opportunity cost in an inflationary environment? The rest of this article tries to provide some answers to these questions.
How deep will the recession be?
I start with this because it has an impact on other answers. At the time of writing western central banks are raising interest rates to try to control inflation. At the same time, we have ‘tax’ rises on consumers through the higher cost of food, energy, and some other commodities. These will hit particularly hard this autumn. Governments will probably have to raise taxes too.
Against this, an increasing amount of western effort and production is being directed to countering the Russian attack on Ukraine, whether this is military hardware or building infrastructure and facilities, to replace Russian energy and other commodities with other supplies. There is also some pent-up consumer demand following the COVID lockdowns, which may benefit areas such as tourism.
The key variable is whether central banks maintain their tough stance. In late 2018 they (or was it politicians?) were spooked by recession and reversed course abruptly. CrossBorder Capital think the Federal Reserve might raise rates this time by a further 200bps, i.e. to the point where credit failures commence before that happens. In my view, in the more political world we live in, they will find it difficult to go even that far, and will again revert to easier policy before the end of 2022.
The position in China may be even more stark. There is no pretence that the PBOC is independent from the Communist Party, and the latter’s number one objective is stability. They will be even more reluctant to risk the first recession since China opened up to the world in 1984, and the volatility that will engender.
So, if I try to peer round two corners, I suggest that we will see a repeat of late 2018: recession will loom until it starts to endanger politicians’ positions, and central banks will then reverse course. That suggests a milder rather than a deeper downturn unless the volte-face is too late.
Have markets discounted a recession?
Some distinguished commentators such as Ed Yardeni are suggesting the U.S. market may hit a new high in 2023. Some tech companies (Netflix, Spotify) have missed their earnings forecasts, but most haven’t, simply because the march of tech has not stopped. The market sell-off is more because of a reduction in investors’ valuations of these earnings streams. If bond yields continue to rise, then there may be further falls coming, but the maths of discounting means that the falls in valuations will be less marked as corporate bond yields rise from 4% to (e.g.) 6% than those already seen. And as earnings come through, stock prices should rise. So Yardeni may be right.
Are corporate (or government) bond markets investable again?
U.S. 10-year government bond yields have topped 3%. Over the very long term, bond yields of reliable states have tended to trade between 3% and 5% in normal times. Of course, they have been outside, both above and below, for much of the last 50 years, but for the previous 160 years that has been their ‘normal’ range. If I am right that central banks change course as the recession looms, government bonds may well benefit from a steepening of the yield curve. While the case for government bonds today is still more about ballast and diversification than the return, they are again investable.
AAA credit corporate bonds are trading at 3.7% (ICE BoA AAA index). That may to an extent reflect the failings of credit agencies, but is a level not far removed from many pension funds’ discount rates. The question, with recession looming, is whether spreads will widen further; I suspect that is likely to be the case as tighter policy bites. But the yields on offer suggest they should at least be in investors’ universes.
Can real assets mitigate the effects of inflation?
Property was the best performing asset class in the 1970s when inflation was rampant at a time of low economic growth. Could it do the same again? The big difference today is valuations: real estate, in particular sought-after sectors, is vastly more expensive than it was in 1970. In a recession, affordability will hit the residential market, and declining demand adversely affect more commercial sectors, as we have just seen in the area of logistics warehouses. So, I doubt it will provide the same protection.
Other real assets, such as infrastructure, may well have underlying inflation-linked contracts, which will provide some protection and be relatively immune from recession. However, if inflation really takes off, price caps will come into play and the contracts may even become unenforceable in the case of a deeper downturn.
Is there a case for holding cash?
I am painting a picture where markets fall further, but central banks do not have the appetite to engineer the kind of recession which is probably needed to snuff out the inflationary surge. Holding cash clearly has an opportunity cost in any inflationary environment such as today’s where the real yield is negative. However, it also gives the flexibility to take advantage of stressed sellers, and this benefit may well outweigh the cost. But this only operates while there is a likelihood of some distress emerging, and the case for holding cash is not a long term one.