Recession: To be or not to be?

Bryan Dooley

This is one of those strange times when markets appear to be sending conflicting signals. Specifically, the 15% rebound in the S&P 500 stock index since bottoming in mid-June suggests a light at the end of the economic tunnel. In fact, second quarter corporate earnings came in better than feared and last month’s jobs reports showed employment remains strong by some measures.

And yet, other economic data point to a slowdown. The US reported an inflation-adjusted gross domestic product (GDP) decline of 0.9% in Q2 following a drop of 1.6% in Q1. Two consecutive quarters of negative GDP growth already meet some analysts’ definition of a recession.

Leading economic indicators also suggest further softness. The US ISM purchasing manager indices (PMIs) for manufacturing and services have fallen 17% and 33%, respectively, over the past year. While the US manufacturing PMI stands at 52.8, the latest reading on the services PMI showed a decline to 47.3. Numbers below 50 in this data series indicate a recession.

Higher interest rates are starting to impact consumers. Last month, we saw housing starts drop by 13%, as new home sales fell to the lowest level in two years. Automobile sales are down about 12% over the past year.

In the fixed income markets, longer term bond yields have declined by 65 basis points (0.65%) since mid-June while short-term interest rates pushed higher, thus making the US government yield curve inverted. The two-year Treasury now yields about 0.34% more than the 10-year bond. Market followers may know this atypical pattern often predicts an impending recession.

With equities suggesting better times ahead and bond markets predicting a recession, which one is right?

The answer to this question lies in how far governments will go to push their monetary and fiscal agendas.

So far this year, the Fed has been rapidly raising interest rates in a bid to stump growth and cool sky-high inflation. In classic form, the US central bank has been acting like an arsonist firefighter attempting to extinguish the inflationary fire caused by its own excessive money printing combined with government overspending during the worst years of the pandemic.

Rising interest rates typically crimp economic growth which often curbs inflation. Raising the funds rate makes borrowing less attractive. This directly impacts the consumer as the funds rate is tied to most other interest rates including home mortgages, adjustable-rate loans, credit card debt and consumer loans. Furthermore, tight credit market conditions slow business expansion plans when their cost of capital increases.

As we have seen this year, rising interest rates can also make the investing environment more challenging. Slower growth and competition with higher bond yields reduce the price-earnings multiple and therefore the price investors are willing to pay for stocks. At the same time, bonds are directly impacted by rising interest rates as existing bond issues with lower coupons are priced at lower market values.

In equities, we have been seeing individual market sectors perform as one would expect prior to a recession. When times are tough, consumers reduce spending on large ticket discretionary items such as automobiles, home furnishings and long-distance travel but are less likely to cut back on essential items such as healthcare and food.

Indeed, healthcare, consumer staples and electric utilities sectors have significantly outperformed the market year-to-date, while more economically sensitive sectors such as financials, industrial and consumer discretionary have lagged. Energy has thrived this year mainly due to supply-side constraints and the war in Ukraine.

The level of credit spreads in the bond market represents another barometer of economic health. The yield differential between a credit risk-free 10-year government bond and an average BBB-rated corporate bond have risen by over 60% since the beginning of the year. This indicates investors are concerned about credit defaults which would likely become more problematic in a recession. Rising credit spreads mean investors now require higher returns on riskier securities.

This economic cycle, like others in this millennium, will ultimately be determined by government. The arsonist firefighters in Washington have caused, or at least exacerbated, all past business cycles in recent history and this one should be no different.

In a normal environment, higher prices are corrected by the higher prices themselves. For example, if consumers must pay more for goods and services, they will simply buy less or find lower cost substitutes which ultimately brings prices back down.

However, today’s economy features government with its hands in everything. Investors should be prepared for more interventions in the form of further interest rate increases, quantitative tightening, increased regulations, price controls, and other fiscal and monetary policies which interrupt the normal flow of business.

In the meantime, markets appear to be calling the Fed’s hawkish bluff. The US, like many other so-called developed countries, continues to spend beyond its means without regard to deficits. Now owing a record $30 trillion in debt, each one percent increase in the US interest rate translates into an additional $300 billion in debt servicing. That’s a serious problem for both the short and long run. Government has less flexibility than it would like us to believe.

In the months ahead, expect backward-looking data points such as employment and headline inflation to begin drifting lower. In this environment, investors should stay well diversified while leaning into quality in their equity portfolios. Bond investors are still better off with maturities inside of five years, thereby benefitting from the most attractive part of the yield curve.

Bryan Dooley, CFA, is the chief investment officer at LOM Asset Management Ltd in Bermuda.

Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.