- The Big Conversation
- Episode 1: Will there be a U.S. recession?
Will there be a U.S. recession?
Published on: October 30th, 2019 • Duration: 14 minutes
In this episode we look at whether there could be a U.S. recession, what the Central banks might do about it and if there might be an end of year sell-off.
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[00:00:02] And the big conversation we're going to be looking at the market topics that matter, such as trade wars and China and the role of central banks. We'll be looking at the risks, but we'll also be looking at the many opportunities that come hand-in-hand with these major recurring themes. Many people are asking the question, is a US recession coming and the reason why this matters is that the last two U.S. recessions led to a significant impact on global asset prices. In fact, some of the world's largest equity markets fell 50 percent on both those last occasions. And now investors are thinking, how should I protect myself or profit from a similar scenario? So what is the evidence that there is a global slowdown taking place? Well, the global slowdown is very clear and has started in the Far East, particularly in China, who last year put the brakes on their credit and then come over into into the European market, where it's had a very big impact on places like Germany.
[00:00:58] The German Purchasing Managers Index for the manufacturing sector has been below 50 for most of this year. And in fact, some would say that German manufacturing is actually in recession. But obviously, a slowdown in the rest of the world is not the same as a recession in the US, which is what matters for risk assets. What is the evidence for a US recession? And there's two camps that are forming. On the one hand, you've got a lot of people who are saying that the recession is here right now and you need to start preparing. And on the other side, there's those who say, well, hang on a minute. The evidence is that a recession may appear sometime in the future. But right here, right now, there's still a lot of juice in the market and a good opportunity to make some money. So let's look at these arguments. Perhaps one of the strongest cases to be made for a recession has been a study of the yield curve in the US. And this is the difference between, let's say, a long dated yield, 10 years and a two year yield, a shorter dated yield. Normally, the long dated yield would be above the short dated yield. Eventually, the yield can come up to the ten year yield. And when it goes above, that's called an inversion. Now an inversion on the yield curve and some people use different parts, but an inversion on the two to 10 year part of the yield curve has preceded each of the last three recessions and the last month and a half that two year, 10 year yield curve inverted. It was only a small amount, but it's still inverted. And people say, well, that counts. Another piece of data that people love to look at in terms of predicting a future recession is the Institute of Supply Management Manufacturing Index, the ISM. And it's very similar to the global PMI’s. And last month this fell below 50 and in fact, it fell to the lowest level since 2009. And the great financial crash, but more importantly than just the headline number was some of the components, the forward looking components. One of those, which is the new export numbers, fell to 41. This was the lowest level that we've seen since 2009, in fact, the lowest level that we've seen in the last 30 years. So this is a very, very low number. And people say this predicts recession. Also within the ISM, it has 18 components. And of those 18 components or sectors, 15 of them are in contraction again. This has never been seen since 2009. So this is a very, very bad number. Some people are saying it is predicting a future recession. There's a couple of other little pieces of data that we have to watch such as the Conference Board's CEO confidence survey. This has fallen to a level which again, has only ever been seen during periods of recession. So the three other occasions it felt the similar sort of levels. We had a recession. But it is a forward looking indicator. This is six months forward. And then we have the New York Fed's probability of recession index, again, a forward looking indicator. And it is saying that in 12 months time, we should expect a recession. In fact, when we got to these sorts of levels in the past. We have only ever had a recession again, forward looking. But when it comes to asset prices such as equity markets, they will price in a recession, well, in advance of that event. And so people are saying, look at these pieces of data. A recession is coming and you need to prepare for it now. So on the other hand, why is it people are saying, well, no, there is no recession coming. Why is it that people can say, I'm comfortable that this data is not telling me to be nervous today? And in fact, you can use the same data. It's all about interpretation and time horizon. If we go back to the yield curve, what we can see here is that the yield curve has inverted before every single prior recession, but it's inverted a long time before the recession hit. And not only that, it has started to steep and again. So the 10 year yield moving back above the two year yield and often the inversion takes place up to 24 months before a recession takes place. So some people look at that very same yield curve and say, yes, it started to invert, but it hasn't fully inverted. And there is still a lot of time before we see a market peak, before we see a recession. Another of those pieces of data, which we can interpret in two ways is the ISM manufacturing index. It has fallen into contraction territory, but not yet recession territory, which is below 45 for this particular index. But what's more important for the US is that you need the consumer in the services sector to also start to come into contraction territory. It's a bigger part of the economy. The manufacturing sector is very volatile, but it's the consumer's services, which is the bigger part. And that needs to contract. At the moment, the non manufacturing ISM is still above 50 and only when it has fallen below 50 could we say that the US is approaching recession type environment. There's also another element to all of this, which is we mentioned that recession is key. But what's more important is how risk assets perform. As investors, we care about risk assets. So even if a recession is on the horizon, is it yet time for risk assets such as equities to roll over and for that sentiment is very, very important. Some people have called this the most hated equity rally in history. So although the US equity market, the S&P 500 has clearly been going up well, we can also see as during most of the rally over the last four or five years, equity investors have actually been pulling money out of the market. They have been selling and liquidating their exchange traded funds and their mutual funds. Really, the only buyers have been corporate buybacks and some transition away from active management to passive management within all of this. One of the biggest debates is about the role of central banks. People look at the central banks and say that once a recession kicks in, they have no ability to stop it. And the example that the Bears will use is that between 2000 and 2003 and between 2007 and 2009, the Fed only cut rates. And yet the S&P 500 and global equity markets only fell. In fact, many collapsed. But on the other hand, people will say, well, look at 2015 16, we had a profits recession. But the US Fed stepped back from raising rates. They didn't relent and they allowed liquidity to pick up again. The Chinese central bank pumped in loads of credit, so they built up liquidity as well. And in Shanghai, the G 20 meeting, they had the Shanghai Accord and this allowed the dollar to stabilize. And between them, central banks allowed equity markets and risk assets to once again take off. We've already seen the ECB say that they are going to return to QE in November. The Fed, although they haven't returned to full blown QE, has started to expand their balance sheet once more. And rather than raising rates, they're now cutting rates. So how do we put it all together? Clearly, we have a global slowdown in manufacturing. It has spread to certain parts of the US. But what matters is that time horizon and lag. It still feels like there could be another 12 months or more before the real elements of recession kick in. And we still need to see it spread to the consumer in the services sector in a meaningful way before we can ring the bell and say, yes, a recession is probably upon us.
[00:07:43] Because the slowdown in the global economy, there's been a lot of chatter about what should be the correct response from global central banks. So here we are today with the ECB. They're about to restart QE. They're going to start buying 20 billion euros of assets a month from November. The US Fed are already buying 60 billion of T bills a month on top of some overnight operations from the New York Fed, where they're adding liquidity to the market and also on a 14 day basis as well. So while these changes come about, why they come about so soon? What should we expect from them and what should we expect from asset prices? Well, first, we look at the European situation. There are some very clear reasons why the ECB are coming back. Firstly, one of the primary mandates was inflation. And inflation often means growth as well. Their inflation target is 2 percent. And although it touched there briefly a few months ago, it has absolutely plummeted away from that level. And so now they're faced with falling inflation once more. But also, growth within Europe has been rolling over in particularly the manufacturing sector. With that, we've seen bond yields in Europe plummet. Now, with bond yields falling, it's been a real problem for the banks. Banks earnings are struggling. So we can see the banks, the eurozone banks in particular, they've been underperforming and selling off effectively with this fall in bond yields and the overall bank index. The euro stocks, European eurozone banks, these are sitting right on the edge. The situation in the US is slightly different. There has been a manufacturing slowdown observed there as well. We can see this in the Institute of Supply Management or the ISM index, which is a bit like the global PMI’s that fell below 50, which is the boom bust level, and it's fallen to the lowest level that we've seen since 2009 and the great financial crisis. But that's only a recent decline into contraction territory. I think what's been more of an issue for the US is that there are funding issues for the commercial banks. So there's been tightness in the ability for banks to effectively borrow and lend primarily in overnight markets, but also on slightly longer dated terms as well. So what this is meant is that the the New York Fed has been providing liquidity overnight and on a 14 day basis. The important thing here is that this is opening the door to future QE, even if it's not QE today. So the key here is that both the ECB and the Fed have both effectively reopened Pandora's box. What should we as investors expect if central banks are restarting QE and expanding their balance sheets? Well, we do have some examples from the past that are relatively clear. So, for instance, the German Bund, which is the 10 year bond yield, has generally been supported during periods of QE, i.e. this gone flat to slightly higher, even more clear as when we've seen an end to QE. Those bond yields plummet within the equity market. I think the equity market that people really care about or really focus on is the S&P in the US and in the US. We've seen very clearly that when central bank balance sheets are expanding and we're here looking at China, Japan, Europe and the US when they've been expanding, the US equity market has generally been rising. And only during periods where those central bank bank balance sheets have been flat or slightly declining has there been more volatility and maybe a little bit of weakness in the US equity market. But what is very, very clear is that central banks are trying to be pre-emptive. They know that the global growth scenario is dependent on liquidity. They know that asset prices in particularly equities are totally dependent on liquidity. And therefore, if they feel that growth is slowing or that there are funding concerns coming into the market, the central banks will come back with yet more liquidity and will double down if things start to get worse from here. There's a lot of pessimism this year, and I think that pessimism comes from the experience of Q4 2018, where the S&P had a very significant sell off 20 percent, which was pretty much greater than would be expected from the macro data behind it. Now, what were the reasons behind that last year? I think there's a whole bunch of them. Firstly, the growth data had picked and was rolling over at the same time yields and we were looking here at the US ten year yield. It carried on going up to a level which in hindsight looked like it was too high for the equity market and the economy had hit three point eighty five percent. The S&P peaked and rolled over fairly soon after that. Then in December, the Fed raised rates a final time. It turns out it was probably one time too many, and that seemed to accelerate the equity market to the downside. I think there's a couple of other two elements probably that were in there. One is that we had hedge fund redemptions and you had baby boomers who are increasingly forced sellers for tax purposes. So what should we expect this year compared to last year? Should lightning strike twice? We know that growth has been rolling over. This has now been very much factored into the last 12 months. The Fed, rather than raising rates, are cutting rates and they are no longer tightening the balance sheet, if anything, they're expanding it again, although it may not be QE and the ECB who were effectively starting to finish their whole QE program where they said they're going to begin again in November, so are adding more liquidity. Now, the baby boomers, they as a cohort are going to become bigger and bigger sellers. That's not going away. And hedge fund redemptions is going to be an issue or part and parcel of every year and every year. That's not going to go away.
I think one of the big issues that people are seeing today is that there are lots of worries around funding and there was a misstep by the Fed in September. And funding markets are clearly problematic and the Fed has still not fixed them. Now the Fed is trying its buying T bills. It is doing overnight repo, but it's still not sorted, the problem. A lot of problems have arisen from regulation, regulation that is built up over time so that certain banks, banks, which might be global and systematically important banks, they have requirements that are capital requirements that mean that the cost of capital to these banks is quite high. Well, it's a little bit of a longshot, but if the Fed keeps on failing by adding liquidity, what they could do is they could change it up by taking the regulations down. What they could do is they could reduce the G-SIB scores, systematically important banks, which effectively will allow these banks easier access to capital. And this could be really interesting for year end, because if these banks have their regulations relaxed, a surprising amount of liquidity could find its way into the market just when most market participants are still very negative and in fact are not positioned for liquidity in markets to rally into year end. So I'm gonna be listening to this. Its certainly being talked about in the market, a relaxation of some of these regulations like, G-SIB scores could see a surprising amount of liquidity into the market and a surprising year end rally into Christmas.