The current global macroeconomic environment poses a dilemma as to whether the next phase of the cycle is a full-blown recession or a softer landing. To this end, let us look at how markets are behaving and what the yield curve is telling us.
Regarding the first aspect it seems clear that the outperformance of defensive sectors is showing us the way towards an economic contraction. Let’s look at how the different sectors have performed in the last weeks and months.
The behaviour of the last six months alerts us to risk aversion. And now, we compare it with what business cycle scholars such as Martin Pring tell us.
There are several macro indicators that warn us of a likely recession given inflation and the central banks’ obligation to preserve the value of the currency, which will lead to a sharp rise in interest rates.
The Michigan sentiment indicator is already showing signs of economic slowdown, as is the pessimism-laden investor sentiment. Some argue that the Fed is going to prick stock market bubbles.
But the star indicator is the yield curve and its flattening. Inverted yield curves occur when bonds with shorter maturities trade at higher yields than bonds with longer maturities. Investors are willing to accept lower relative yields on longer-maturity bonds if they believe that interest rates will fall in the future due to slower economic growth.
A 2018 Federal Reserve study showed that the lead time between yield curve inversion and the onset of a recession ranged from 6 to 24 months. But there are as many curves as we want. So the dilemma shifts to the time frame chosen to plot the slope of the curve.
Duke professor Campbell Harvey, who was the first to document inverted yield curves as an indicator of recession, compared the yield on the three-month Treasury bill with the yield on five- and ten-year bills, rather than the much-used two-ten year. In the financial sector, the former is the more decisive.
The Fed is not usually successful in achieving soft landings in the face of recessions and I personally believe that so many rate hike expectations will not materialise in a housing market where thirty-year mortgages are already above 5%.
An easing of supply chain problems, which is expected to occur this year, combined with higher oil production and the end of the war could help ease inflationary pressures.
Is the market wrong or are we wrong?
The market is wrong in the short term and we must avoid being wrong in the long term.
Many investors have lost a great deal of money by relying too much on their ability to predict what is going to happen. We should not be tempted to make radical changes to our portfolios and now that some technology stocks are worth half or a quarter of what they were worth a few months ago, it is worth keeping an eye on them in case rates do not rise as much as the market is predicting today.