Roger [00:00:00] This year has been one of the most difficult on record for a combined bond and equity portfolio. And as a result of this performance, many professionals have been forecasting an imminent recession. But at the same time, the US labour market has remained relatively resilient. In this, our last episode of 2022, we'll look at 10 key charts for next year. If 2022 was the year of the price shock, will 2023 be the year of the growth shock?
Roger [00:00:25] That's The Big Conversation.
Roger [00:00:32] Investors love to hear trade ideas, but in some ways what's more important than that is to have a market framework that helps to identify the key risks and challenges to our views. The best investors always say that risk management is more important than idea generation. So using 10 charts we'll look at some of the key battlegrounds that could define the outlook for 2023.
Roger [00:00:52] We're going to kick off by looking at the US because that's obviously where most of the real battlegrounds do lie at the moment. But then we're going to branch out and look at some of the things in the rest of the world. Some of them look unconnected, but all these are in many ways part of the same framework.
Roger [00:01:05] Now, looking at the US, I think the key thing here is that we've got recession. Are we going to get a recession? How deep will that recession be? And then what's going to be the policy response? Do we get a pivot or a pause?
Roger [00:01:17] And the first chart I want to look at, which really gets to the crux of all this, is unemployment and recessions. And it might seem obvious, but really unemployment is probably going to be the main factor next year that defines whether we get a recession, and how deep it will be, and then ultimately what happens within the equity market. And this first chart really brings home the importance of this relationship, because, if we go back to the 1960s, you can see that unemployment has started to turn before a recession starts. On almost every occasion. There are a couple in the period of inflation in the 70s where it did turn just as we hit recession. But the point here is that we haven't really started to move meaningfully higher in unemployment yet. Now, obviously, unemployment is prone to revisions. It's a very backward looking data point. And already we can see disparity between the establishment survey and the household survey. And we're starting to see anecdotal evidence that we are getting job lay-offs, particularly within the tech sector. But what should really strike us about this chart, is that recessions and higher unemployment come hand in hand. So far, we are not seeing a rise in unemployment. In fact, we normally see the big acceleration in unemployment during the middle of a recession. So this suggests that the recession, if there is going to be one, is still some way in the distance. And perhaps there isn't going to be one. But then that brings a problem for the Fed, because the Fed trying to fight price would worry about growth, if unemployment doesn't pick up and growth stays relatively robust. So the speed with which unemployment picks up, even with revisions which we can expect to come through and the amount of unemployment that we get; so how high will unemployment go, is going to be one of the key factors, if not the key factor for defining the sort of recession that we're going to get.
Roger [00:02:58] Now, one of the key elements around that, in terms of what could cause unemployment to pick up significantly; we've seen obviously the tech sector starting to shed jobs, but I really think it goes down to housing and construction, this very, very big sector which employs a lot of people. And if we look at the NAHB housing index, I've inverted it here and I've mapped it onto that unemployment index. You can see that the two pretty much ebb and flow together, except that, the NAHB housing Index generally leads unemployment. So far we've seen this quite incredible move on this chart it's up, but actually that's the index, the NAHB index falling, has been one of the biggest moves that we've seen in the last 20 years. It's a faster pace than we saw during the midst of the mortgage crisis of the 2006, 2007 period. And it only just lags behind that shock of COVID. This certainly suggests that unemployment is going to pick up with a lag to this decline in housing and obviously construction being an important part. So we've got to keep our eye out on that unemployment data, because it feels like these are the points that are coming through, some of them anecdotal suggests that unemployment will pick up and therefore we will get a much bigger recession. But obviously, when we look at unemployment and recession, there is a bit of chicken and egg here. Sometimes it's the recession that creates unemployment, sometimes it's rising unemployment that creates recession. But nonetheless, the two go hand in hand, even if they are coincident, and the two are very much going to be the drivers of the next chart.
Roger [00:04:26] And the next chart is the S&P 500, because you could be saying, well, unemployment, okay, recession bad for households, etc.. But what about financial assets? And when you map the S&P onto recessions, you can see that there is a major low in the S&P, either in or just after every single recession that we've had. So if we still got a recession ahead of us because we've still got unemployment ahead of us, then potentially we still have a major low in the S&P ahead of us. Now, there are one or two caveats that we can look at here, which might say, okay, maybe there are an alternative, there is an alternative scenario. The first one was 1980 and 82. These were two recessions, but, we did get a higher low in 1982 than in 1980. So if we get a big enough kind of into recession rally, then that's one potential. Similarly, if we haven't actually had a recession yet, is there potential for the equity markets still to rally further from here. So the recent low that we've seen in terms of 2022 is not the actual low. And that maybe the comparison there is 1987 to 1991 where the market did manage to rally. But it does feel from that housing data and from the anecdotal evidence from the tech sector, that unemployment will pick up sooner rather than later. And therefore, it feels like that recession story is probably one for 2023.
Roger [00:05:42] Then the next chart I want to show you is one which is Yields versus the S&P, because obviously this year it's been all about those higher prices, higher inflation and a policy response of a hawkish Fed and tighter rates. That's meant that, bonds have sold off and yields have gone up. At the same time that the S&P has sold off. Now, as we filmed this at the beginning of December, so in the first couple of weeks of December, we were starting to get some signs of yields falling and equities starting to fall at the same time. Now, the reason why this matters is that we've been adjusting for price in 2022. This was all about prices getting ahead of themselves in terms of what most people expected, even though some forecast it, and then the Fed having to catch up and then going beyond expectations. And then bonds in particular adjusting for that, with higher yields, bonds selling off. And the equity markets sold off, generally led by the tech sector. Within this, we actually saw many stocks performing pretty well, so lots of rotations. Will we now get that correlation event where all equities sell off? And this is why that unemployment data is so important, because why do you get lows during periods of higher unemployment? Well, that's because you get redemptions. You get liquidations, because if you fear job losses, or potential losses of future earnings, you will sell down some of your equity holdings in order to offset that, which is why we get these correlation events during those recessions. And that's when we get everything selling off, which means that, some of the winners of 2022 could become losers in 2023. Not necessarily the losers, but just because we've had that good performance, particularly in the commodity sector, we get a true proper recessionary slowdown, then you normally get correlation. And pretty much all equities sell off together. Doesn't mean they sell off by the same amount like we saw often in 2008. But it does mean that there could be risks to some of those best performing stocks from 20 from 2022. So we've got to be wary that we could move from bonds down, equities down, to bonds up, and equities down, a very different dynamic. And in fact, if we look at the inflation period of 19, the early 1980s, we actually saw that when bonds started to roll over, those yields started to fall, so bonds started to rally, yields started to decline. We actually got more performance from bonds than we got from the equity market. Yields had actually often fallen substantially before equities made a proper low, and then started to rally. And often they rallied again once growth picked up. So we have to be careful that we don't interpret the current environment like we did between 1985 and 2020, when that period saw two year yields falling as interest rates were being cut before we got the rump of the equity market sell off. That was the period of moderation when the Fed was supporting growth. This is a period where they are fighting price like they were in the late 70s and early 80s so it could be a very different dynamic.
Roger [00:08:27] And we can see this now when we look at things like the yield curve and this is already playing out in very much real time at the moment in that again at the beginning of December, we've seen the 2yr/10yr portion of the yield curve. The 10 year yields minus 2 year yields has gone to -85 basis points, which is the steepest inversion that we've seen since 1980 and 1982. And this kind of makes sense because if the Fed is truly fighting price and not worrying too much about growth until they've got a control on price, then they will continue to raise rates until they think they have got a handle on prices. Now there comes a point when those higher rates should impinge on growth. So long range yields 10 years and 30 years should continue to fall relative to two year yields, which should stay sticky or even rise, and even if you get a shift down in the curve, so all yields falling, in this environment where the Fed is doing more than people expect, growth and inflation expectations at the back end should fall if they really have got a handle on price that starts to impact growth. So you would expect the yield curve to invert. And again, this goes back to comparing to that period of moderation because there's still a lot of people who expect the yield curve to invert, and then start to steepen into recession and therefore into the lows in the equity market. But again, that was that period of moderation. Go back to 1980 and 1982 and here you can see that the yield curve carried on its inversion to its deepest inversion, deepest inversion, right into a recession; with lots of volatility in that yield curve, it went up, it went down, in terms of that steepness. But it carried on going down into the recessions. This could be the same thing where they keep on being quite tied to the front end and the back end prices out growth with those yields falling. So the yield curve could be that indicator that starting now, that tells us that this could be much more like 1980, 1982 than any period in between.
Roger [00:10:17] So this then comes all on to what's the policy response from the Fed? Because at the moment there is this pivot, versus pause type of view, and a lot of people think that the pivot is simply a pause, which, as I've said before, it's not. To me, a pivot is, you raise rates and then you cut rates. A pause as you raise rates and then you pretty much hold them. At the moment, the Fed's fun curve is still really looking at this being a pivot, and you can see this in the early part of next year. It's really Q1 and Q2. You can see this V-shape, which is that V-shape is when the interest rate cycle is currently being priced to turn. Now, the Fed funds curve has not been a brilliant predictor so far. We've gone from around about 4% in terms of the terminal yield, terminal interest rates back in September. It's gone to 5% just above, just below. And we've seen the pivot point move from February through April, we're currently around about May. So it's not necessarily a great predictor. But what really matters here is that; will the Fed want to pivot early, because there is already a recession? Will they want to pivot early because they think a recession is coming? Or they want to continue to tighten till they know that there is a recession that caps prices? And historically, the Fed has never been pre-emptive. They'd never gone, Oh, we think there's a recession coming, therefore we're going to stop and turn. They nearly always wait for the recession because the big risk for the Fed is that if they turn too early and risk assets rally and we actually get growth coming back before they've got a handle on prices, so inflation, then inflation could pop back something that we saw regularly in the 1940s and 50s where you had sequences of peaks. And similarly in the 1970s, there were three consecutive peaks of inflation. They won't want to do that. They won't want inflation to get ahead of themselves. They will probably want to make sure that unemployment picks up so that we don't get wages getting sticky, which is where you often get that really entrenched inflation from. If it's simply commodities and effectively the supply chain. Then once that rolls over, we could be in a safer position. But if wages become sticky, that's when you start to get inflation. And so they won't want to turn too quickly. But the market is still pricing a pivot, will we see that pivot move towards more something like a plateau, which would be a pause. That's the real sort of main battleground at the moment.
Roger [00:12:29] But outside of the US we've also got some very significant areas that we should be watching. And one is that this probably will be a global slowdown if and when it happens. And what are the signs that we can see that? Where can we witness this happening? And we can see this in things like currencies. Now, so far this year, the Japanese yen has been on the back foot. It's been on the back foot because they've been doing yield curve control. They've also had the issue with importing energy. So the energy costs have been going up. That's been diluting the yen. The yen has been very weak. But over the last few months it has been consolidating versus the Aussie dollar. Now the Aussie dollar is normally that sort of on/ off risk on/ risk off, growth/ no growth type of currency, because it's an export of commodities. Aussie dollar versus Japanese yen. Aussie dollar has been performing very well over the last two years, but it's been consolidating and now it looks like it's got the potential to start breaking down. So if you want to look outside of the US, and some of the ideas that the global growth story is starting to really come unstuck, then Aussie dollar yen would be one because Aussie dollar rolling over versus the yen would mean that the yen is not having the problem with the high yields, potentially not from higher inflation, which has been the problem in 2022. And the Aussie dollar is not getting the benefits of higher prices in commodities, largely because the high prices that we've had have not been combined with a lot of demand and a lot of volume going through. So we can watch the Aussie dollar versus the Japanese yen for signs that the global growth story is starting to come unstuck. And then if it does, do we see some of last year's winners, as I mentioned before, in the US equity market, but the global market, do we see some of last year's winners, or 2022 winners, starting to come unstuck in 2023?
Roger [00:14:11] And here we've got the FTSE. Now this is a logged chart of the FTSE, the full of old world stocks. So therefore lots of energy companies, lots of mining companies and lots of staples companies. This is still near the all time highs and it's done relatively well over this year, having underperformed things like the US for a very long time. But the point here is that if we get a true recession, a true global recession, then even things like energy stocks and mining stocks, despite the long term positive story, because of this massive supply demand imbalance over the next ten years, these stocks will come under pressure. Because remember the story during COVID, even though supply demand imbalances existed in the energy and commodities space, when demand collapses, you can see that commodities and commodity stocks can have a difficult time as well. It won't be as bad as that. We won't get negative oil like we did back then. But you can see it comes under pressure. The issues existed before COVID. They were laid bare after COVID, when we had that demand impulse from the fiscal and the supply shock because of COVID closing things down. But similarly, if we have a true recession in 2023, then we could see some of that demand falling. And so even some of these boring stocks from 2022 could come under pressure. And the FTSE 100, which has held up so well, may be one of those which struggles relative to how it's done in 2022.
Roger [00:15:28] Then just turning very slightly away from from the equity market. We've got to look at the energy market, because the energy crisis was very much the story through the middle of the year, but it's kind of died a death towards the end of 2022. But it's just been deferred. It's not been removed from the environment. It will come back and the issues are still very much there. And when we look at things like baseload, this is the front man, future baseload electricity in Germany. I've used a log chart here because when we use a non log chart it looks like it had an enormous spike and came all the way back down to a starting point. But on a log chart you can still see it's roughly three times higher than pretty much the highs of the previous 10-15 years. Energy costs are still high within Europe. The energy crisis is still there, bubbling away in the background. At the beginning, middle of December, there is a cold spat going through Europe that could cause a few of the supplies, that have been kind of built up, to get drained. And therefore, we could be facing another issue with energy throughout 2023 and even into 2024. This has not been removed. It has only been deferred. And so therefore, energy is going to be a very serious story throughout the next year.
Roger [00:16:36] Then finally, I've left inflation to the end because I could have started off with the US CPI chart and we could have said, has it peaked? Is it going to roll over quickly enough? But that inflation story is one which is is going to play out globally. And I wanted to come on to Japan because we talked about Japan already, and yields in Japan, and the Japanese yen. But what matters with Japan, is that Japan is a major creditor nation to the rest of the world. It basically invests loads into foreign assets. And so what happens in Japan is critically important to the flows of capital around the world. And at the moment, the Japanese, the Bank of Japan has been basically saying we will cap yields on the ten year space and 25 basis points with the recent pullback in global yields. That's taken some of the pressure off. Remember, when they cap yields, they're effectively diluting their currency, that was yen weakness. When yields started to come back, some of those kind of global growth story started to roll over. Yields fell. That pressure came off. Yen started to rally. But CPI in Japan has been picking up. It's been delayed relative to other regions, but it is picking up. If you have inflation picking up in Japan. So that real returns for Japanese assets is actually still falling. Even if global yields have already peaked, then you could still see some issues in terms of pressure in Japan. The reason why that matters is that because if yields in Japan go up to 1%, 1.5%, they will have a knock on effect into all other markets. So US yields will go up. European yields will go up. But they might not beat the levels that they've previously got to, but they will still be impacted up if Japan walks away. So Japan will be watching critically its own inflation story. At the moment, it's still probably within the realms of what's acceptable. But if it moves dramatically from here, then that could be a problem. It feels like it should rollover. Remember, the energy crisis has not gone away. Japan imports its energy needs. There's a hope that that recession, global recession can kick through and cap inflation in Japan. But if we don't get a recession in the US, we don't get the global slowdown we expect, then Japan could be a problem and Japan could drive yields elsewhere higher if they have to walk away from yield curve control.
[00:18:41] So hopefully they're a very disparate group of charts that I've looked at. I focussed on the US because that should still be our own kind of core area to be looking at. But there are these other issues. There is geopolitics at play, there is the energy crisis at play. It is a global story and commodity prices have perhaps not been acting as we'd like them to, particularly given that recently we've been talking about China reopening. We'd expect commodity prices, particularly energy, to pick up. It feels like that recession is a story for 2023. How deep will it be? But we'll probably get an idea from things like Aussie dollar yen and then we'll get an idea on whether the Fed can do a pivot. The reality is, if we get a big slowdown today, the Fed can pivot early. If we don't get a slowdown or a big enough increase in unemployment, particularly in the US soon, then the Fed will have to probably be tighter than we expect, for longer than we expect and they might have to actually generate the recession in the back end of next year. If we don't get it in the front end.
