No landing in sight

Paul Samuelson, winner of the Nobel Memorial Prize in Economics, famously remarked back in 1982 that “the stock market has predicted nine out of the last five recessions”. Forty years later, it looks like the market has done it again. The bear market of 2022 was driven by investors anticipating a recession this year. Of course, there will eventually be another recession, but so far, the global economy continues to defy the gravity of higher interest rates.

To be fair to panicky investors, they weren’t the only ones who saw trouble ahead. With the war in Europe, an energy crisis, and the highest inflation in forty years, central banks themselves were forecasting that their rate hikes would eventually lead to recession. In fact, revised data shows that the Eurozone has actually slipped into one already, and the Federal Reserve’s (Fed’s) own model still predicts one in the United States in the next twelve months.

After all the debate last year about soft or hard landings, markets almost appear to have lost interest in the economy. Despite higher interest rates than expected, government bond yields are largely unchanged on the year, except for the UK. As for stocks, the upturn in global indices from Q4 last year closely followed the upturn in GDP (gross domestic product) forecasts for 2023, which made sense until the sudden infatuation with AI (artificial intelligence) caused a spike in a small number of large US tech stocks. At some point, the economy must matter again.

Are central banks trying to cause a recession?

The big game-changer for investors in recent years, apart from the re-emergence of inflation, has been the aggressive counter-stance taken by central banks. For decades, investors could rely on them to support markets. Now, in their fight against inflation, they acknowledge that their rate policies will hurt economic growth and financial markets. Why would they do this?

The US Fed has a dual mandate – to protect jobs and price stability. After the GFC (global financial crisis), employment and inflation were so weak that they could stimulate the economy with rock-bottom rates without worrying about prices. Now the post- COVID-19 job market is so tight that they believe a recession, if one happened, wouldn’t cause too much unemployment. Time will tell if they’re right, but until then, we should expect USD rates to stay over 5%.

The Bank of England also has a dual mandate – price stability and financial stability. This explains why they have insisted on raising rates, yet at the same time stepped into the bond market when the Truss-Kwarteng budget caused gilt yields to spike. It also means that they would tolerate a recession unless a housing crash were to threaten the banking system again. So, the current market expectation of 6% GBP rates does not seem unrealistic.

The ECB (European Central Bank) has only one objective – price stability. During the Eurozone crisis, they stretched their remit to protect the sovereign bond market, but we remember that they also raised rates in 2011 when inflation went over their 2% target. So we shouldn’t be surprised that they continue raising EUR rates now, even though the Eurozone is technically in a recession, and we can see EUR rates approaching 4% in the second half of the year.

It’s worth noting that most macroeconomic models that are built around changes (to interest rates, bank lending, money supply, jobs etc.) indicate that a recession is on the way. But the expected levels of rates and unemployment are still very mild by historical standards. So it would be reasonable to expect some slowdown in the next year, but not a bumpy one.

Are bonds back in fashion?

With corporate and mortgage borrowers facing higher rates on their debts, savers should conversely be receiving higher yields on their fixed income investments. This might not be the case with cash deposits, where banks set the rates, but in the open markets, bonds are yielding several percentage points higher than eighteen months ago and are back in the portfolio discussion again.

Despite the higher yields though, the bond market is not back to normal. First the yield curve is inverted, meaning that longer-term bonds are yielding less than shorter-term bonds. This makes sense, if inflation is falling, recession is coming, and central banks are going to cut rates. But as we’ve found, this may take longer than expected. Meanwhile, there is still upward yield pressure from higher rates and official selling. For now, investors can err to the shorter duration end of the market.

Also, if recession really is imminent, then this should be reflected in credit spreads, the extra yield that lower-quality bonds pay. In IG (investment grade) indices, the spread is above average but not at recession levels. In HY (high yield or sub-investment grade), spreads are close to average, even though we are starting to see defaults in the lower-rated end of the credit space. So this may not be the time to sacrifice quality for more yield.

From a multi-asset portfolio perspective, the attraction of bonds is that they provide a defensive cushion when risky assets are under pressure. Of course, they completely failed at this last year when inflation hit both stocks and bonds. This correlation issue seems to have improved this year now that inflation is declining, but it’s still too early to be confident that it’s back to normal.

Stocks to party like it’s 1999?

The fact that most stock indices are still below their 2021 peaks may feel like a bear market, but now that global indices are up over 20% (in USD terms) from
their 2022 troughs, we’re officially in another bull market. History shows that it’s possible to have bull markets within longer bear markets, as in 2001, 2002, and 2008, so we shouldn’t get too carried away yet.

Pessimists point to the unusually narrow nature of market returns this year, particularly in the US, where a small number of huge ‘mega cap’ tech stocks have driven almost all the index returns. As described elsewhere, this has led to an extremely wide gap in returns between the normal capweighted index (which weights stocks by their size) and the equal-weighted index. Today’s gap has only been exceeded twice in the past, at the ends of 1998 and 1999.

Looking at returns after these previous peaks reveals very different investor experiences. Post 1998, the tech sector posted huge gains for another year, and the more diversified equal-weighted index lagged the broad market by 9%. Post 1999, the tech sector collapsed, dragging down the market. The equal-weighted index was actually positive for another year before declining in the broader sell-off, but by far less than the cap-weighted index.

Trying to map today’s market onto such historical extremes is dangerous, but there are at least two important takeaways. First, is that narrow markets tend to reverse, although it can take some time. Second, is that today’s valuations, while above average in the US, are nowhere near previous bubble levels and still below their COVID-19 peak. So any reversal in market breadth is unlikely to take the rest of the market down in a similar fashion. What happens to the economy should be more important.

What’s an investor to do?

First, for fixed-income investors, it is now possible to build an attractive liquidity reserve with relatively low risk. Given the shape of the yield curve, investors should not have to stretch their maturity or credit profile to achieve 3-4% in EUR or 5-6% in GBP. As inflation risk gives way to growth risk, bonds can again play a defensive role in multi-asset portfolios.

For equity investors, we may have seen the bulk of this year’s index returns already. But as we have already seen, if the eventual economic landing is pushed out further again, the market can continueto run. Also, this year’s returns have come from a very narrow range of stocks. While such narrow rallies preceded reversals in the past, today’s valuations are not particularly stretched outside of the US mega-cap leaders, and therefore there is plenty of room for other stocks to grow from here.

In summary, we have been surprised by the resilience of the economy, although we don’t expect it to withstand higher rates forever. The obvious lesson from recent years though should be not to invest according to economic forecasts. So even though the next recession is always getting closer, trying to predict and time it is less useful than constructing a portfolio that can weather different economic conditions. And the good news is that markets now offer us better choices than we’ve
had for some time.