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 June suggests a light at the end of the economic tunnel, second quarter corporate earnings came in better than expected and last month’s jobs reports showed U.S. employment remains strong by some measures.
And yet, other economic data point to a slowdown. The United States reported an inflation-adjusted gross domestic product decline of .9% in the second quarter following a drop of 1.6% in the first quarter.
Two consecutive quarters of negative GDP growth already meets some analysts’ definition of 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 since June while short-term interest rates pushed higher, thus making the U.S. government yield curve inverted.
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 U.S. Federal Reserve has been rapidly raising interest rates in a bid to stump growth and cool sky-high inflation 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 by making borrowing tied to mortgages, adjustable-rate loans, credit card debt and other consumer loans less attractive.
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 seen 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 and travel but are less likely to cut back on essential items like 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 has risen by over 60% this 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 will ultimately be determined by government.
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 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.
In the meantime, markets appear to be calling the Fed’s hawkish bluff. The U.S. continues to spend beyond its means without regard to deficits. Now owing a record $30 trillion in debt, each 1% increase in the U.S. 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 they 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's Cayman office, located in Camana Bay, at +1 345 233-0100 or visit www.lom.com for further information.
This article was originally featured in the September/October 2022 print edition of Camana Bay Times.
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