Recessions, Yield Spreads, and Markets
• Discussion of the growing inflationary concerns and potential impact if these trends lead the global market recession
• Review of the labor markets, housing industry and household wealth data and its role in supporting forward economic growth
• Analysis of recent market performances by sectors and asset classes and their correlation to rising interest rates and recessionary fears
It may be an understatement to say the markets are more challenged this year than last year. Inflation is running at a four-decade high and creating an environment for rising recession fears. Add to that the largest ground war that Europe has experienced since World War II, and there is little surprise that markets are reflecting a heightened level of investor nervousness. Against this emotional backdrop, the momentum that until recently carried markets to new highs has now accelerated a sell-off reminiscent of the pandemic routing just two years ago.
Given this environment, there was also little surprise that the March Consumer Price Index (CPI) jumped by an annualized 8.5%. Although this was a wake-up call to the markets and to the Federal Reserve, consumers had already begun to feel the pinch from rising fuel prices, higher interest rates, strained pocketbooks, concerning outlooks, and most certainly the shock of the grocery store checkout lane.
Now, higher prices were suddenly more visible headline risks for the central bank and its need to dampen inflationary pressures (tightening monetary policies and hiking interest rates). The bigger risk was the possibility that overly aggressive monetary policies would suddenly stall growth and add further turmoil to the markets, and that recession watch fears would become self-realizing.
Recession fears do seem to be on the rise. A growing number of global financial institutions, such as Deutsche Bank and Bank of America, have already begun their recession countdown. And according to a recent Bloomberg Markets survey, investors have as well, with 48% of respondents expecting the U.S to be in a recession by next year. Considering the escalating war in Ukraine, pricing pressures, future rate hikes, and upcoming midterm elections, hurdles seem to be just ahead.
Yet, these issues aren’t specific just to the U.S. The International Monetary Fund (IMF) is forecasting global economic growth to slow to 3.2%, (a decline of 22%) while estimating global inflation to spike to 7.4%. Add ongoing pandemic-related shutdowns in China and the continuing loss of life and economic destruction in Ukraine, and good news is in short supply.
These inflationary pressures began building in lockstep with the surprisingly rapid economic rebound from the spring 2020 Covid-induced recession. Early in the pandemic, the Federal Reserve provided historic monetary support and low rates, bolstering the economic recovery two months into the recession. This surprising recovery set the stage that led to last year’s supply chain shortages and building inflationary pressures. Putting into perspective how quickly pricing pressures escalated, you will recall that last year we viewed inflation more transitory as the February CPI inflation index had spiked by 1.7%. Thirteen months later the spike was 8.5%. As inflationary pressures have persisted, so have the bets on tighter monetary controls.
Although markets have already digested one interest rate hike of 25 basis points (¼%), expectations are for another rate hike in May of 50 basis points (½%), with more to follow. This accelerating policy of playing catch-up worries investors who fear rising rates will curtail economic growth—a worry already impacting the financial markets.
Even though the past months of escalating prices have given consumers pause, recent consumer surveys have painted a brighter outlook than might be expected. Despite the headlines, consumer balance sheets remain strong, household savings are still a healthy 6.3%, and job markets are tight. A recent University of Michigan Consumer Confidence Survey is now at a three-month high. Although survey respondents forecasted inflation of 5.4% through next year, the outlook for five years from now drops to a more “average” rate of 3%.
Also contrary to past economic/recessionary signals, labor markets continue to surprise to the upside, with job openings near record highs (1.9 job openings per unemployed person), and unemployment levels are sitting near historic lows of 3.6%. Although wage inflation is a concern, considering labor shortages, the job markets are not forecasting recessionary indicators. Instead, they are indicating the more bifurcated labor shortages in both the professional and service industries.
Housing activity has also held up well and, despite a few hiccups, has continued a growth trend that began back in July 2010. Although housing sales collapsed in March 2020 at the beginning of the pandemic, by July 2020 sales were back on track. The past few months have been a bit rocky with reported pending sales in March continuing a five-month trend of negative sales growth, off -1.2%. Mortgage rates certainly contributed to the slump as rates rose over the past five months from a low of 2.7% to a current 5% and rising. Another contributing factor, though, is housing inventories. Although they are up 4%, they have more ground to make up to bring both prices and demand back to more normal levels.
Despite rising rates, demand continues to drive prices. The median home sales price rose an annualized 18% in March, slightly off the annualized growth rate of 25% in February. Among other positive signs pointing to a stable housing market were the 23-year lows in mortgage delinquency rates. In past recessions where housing has been one of the underlying factors, the issue was overbuilding or questionable underlying homeowner credit issues. Neither appear to be the case in this market cycle.
Today’s markets are digesting the past few months of headline inflation worries, recession fears, and overseas conflicts. Market volatility has increased throughout the year, and sell-offs have left few asset classes unscathed. Broadly speaking, all major global exchanges have either fallen into correction territory this year (loss greater than 10%) or they are flirting with bear market territory (loss greater than 20%). A few exceptions are commodity-specific—oil and natural gas, precious metals, and agriculture. The fixed income markets have not provided much solace either. Longer term Treasury bonds were down 17.40% through this writing (April 26), given their direct correlation to rising rates, while shorter three-month maturities were off by 0.21%.
Despite the recent market decline, some sectors of the market were in positive (or near-positive) territory through yesterday’s close (April 26). Traditionally, those sectors are considered to be defensive during an inflationary or recessionary period and are comprised of stable operating companies with quality, consistent earnings power, and visibility or assets that generate or store value. On a year-to-date basis, sectors in positive territory were energy, consumer staples, and utilities. The larger outperformance in energy was related to curtailed oil and natural gas imports from Russia and the subsequent spike in energy prices. Honorable mentions with mid-single digit losses were materials, health care, and real estate. Unfortunately, market detractors were the post-Covid darlings, technology and communication services.
Where the market will trend throughout the next few months is difficult to forecast, but a few takeaway thoughts are worth considering:
- The current headwinds of tightening monetary policy, midterm elections, inflation, and geopolitics will continue to add market volatility.
- Dividend-paying stocks outperformed broader equity markets before, during, and after the initial Fed rate hike.
- Companies continue to report earnings that are above consensus estimates, implying that a number of companies are still performing well during periods of rising inflation.
- Ned Davis Research has provided a reminder that on average, the S&P 500 gained 24% six months after reaching a recessionary low (and 32%, twelve months following the post-recessionary low).
- The challenge for investors is that stocks will recover long before their optimism returns.
Several issues contribute to an economic recession, including:
- High interest rates. Rates have been discussed and are being addressed by the Federal Reserve; successful resolution is yet to be determined.
- Stock market crash. Although the markets have indeed corrected, companies are still reporting positive earnings, and revenue growth and earnings multiples are returning to more reasonable valuations. As we have already mentioned, in a typical market recession, all sectors are not created equal. Even during a market downturn, some sectors and stocks typically do well.
- Collapse in housing, jobs, manufacturing, and consumer spending, and asset bubbles
Considering the broader issue of economic challenges, this information is worth noting:
- The job markets are strong, with unemployment levels near record lows, and available jobs outnumber the people looking for jobs. Meanwhile, average annual wage growth rose by 5.6% as of March 31.
- UBS Global Wealth estimates that consumers accumulated excess savings of about $2.5 trillion during the pandemic.
- Household net worth at year-end 2021 was approximately $150.3 trillion, up 8.2% from the prior quarter and 14.4% from the prior year-end period.
- Most economic indicators remain in positive territory, including the Federal Reserve Beige Book’s more upbeat assessment on the economic environment. ISM Manufacturing and ISM Services Indexes remain in growth territory with visible signs of supply chain resolutions. Manufacturing production data reported in March was the third consecutive monthly improvement, and the level of production is its highest level since 2008. The Dallas Fed Manufacturing Activity index reported investment intentions remain above trend, while six-month capital spending expectations were at their highest level since March 2019. Finally, inventory supplies remain low, especially in the manufacturing and home building businesses.
- Headline Covid concerns are diminishing.
- The U.S. dollar is rallying (strengthening) in tandem with the Federal Reserve’s monetary tightening, which helps lower import costs and raw materials (deflationary).
- Real GDP growth, while expected to decline in Q1, is still predicted to remain positive this year and into 2023.
- One often quoted indicator of an impending recession is the inversion of yield curves, meaning longer-term yields are falling faster than shorter-term yields. This occurs when demands for longer-term Treasury notes surge as a result of investor concerns for the markets. We have seen this occur a few times over the past months with inverting yields between 2-year and 10-year Treasury notes, but the inversions have been fleeting. A more reliable metric is the relationship (yield inversion) between the 10-year and the 3-month Treasury. As indicated in the chart below, looking backward 50 years, the curve inversion (below the zero-axis line) has always occurred before a recession occurs, and this has not been the case this year. Today we still have a gap of 1.88% between the two notes; that is, the 10-year Treasury has a higher yield than the 30-day Treasury. This may indeed change as the Fed increases short-term rates, but we still have room and time.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.