April 2022 - Recession may not come from inversions. But it still may come.
Global equity markets had their first positive month of the year while bond markets were still negatively impacted by inflation, with a small rebound observed last week, especially (and surprisingly) in the long-dated bonds. Overall, the feeling is that markets are looking for a direction, and lower volumes than usual (between 15 and 30% less) clearly indicate that cash is not yet ready to be totally deployed.
The exceptional financial occurrence in March was undoubtedly the US curve inversion: the two main treasury spreads, 2y/10y and 5y/30y, entered negative territory while shorter notes started to trade at higher yields than longer ones. Historically, such a movement in treasury yields, when it lasts for more than several weeks, predicts an oncoming recession (normally within 6 months to 2 years). The reason for that is the negative impact on the financial system, since banks’ profits are strongly reliant on rates: banks traditionally use short term deposits to grant long term loans, therefore if they are paying more than they actually receive, they will no doubt avoid giving loans in order not to be hit by losses. Having said that, and as we see now for quite a long time, traditional signals do not always lead to anticipated results. And this could be justified by the fact that bank loans are not such an important part of the total US credit universe anymore, as it was the case back in the 80’s, (indeed today they represent only around 30%). In fact, corporations are now mainly issuing bonds to fund their activities and additionally, the emergence of fintech companies has brought some aggressive competitors into the credit world. Also, a large part of loans and mortgages are now securitized and sold on the capital markets, so the banks can further leverage their capital. Finally, when we look at the charts, financial companies are more correlated to the US 10-year treasury yield than to the spread’s curve, since the 10 year is considered being the ultimate indicator for growth, and since the beginning of the year, as opposed to past curve inversions, the 10-year treasury yield has risen from 1.51% to 2.44%. Therefore, it is far from certain that this particular curve inversion will in fact, lead to a recession.
During the March meeting, Fed Chairman Jerome Powell announced a rate increase of 25 bps, the first since 2018. He also said that a total of seven rate hikes (if each will be of 25 bps), would be a possibility for this year. Details regarding the Fed’s plan for quantitative tightening will be announced during the next meeting in May. Powell is confident the labor market is strong enough and the economic data resilient enough, so he can increase rates aggressively to fight inflation, which continues to hit a 40 years’ record. However, what the Fed seems to (deliberately) ignore is the impact of higher rates combined with more job offers than demand, on companies. Indeed, the next recession could come not from the curve inversion and its impact on banks, but rather from the unbearable burden of the cost of both labor and funding which could lead some companies to slow or even stop production. Powell may be mistaken by thinking that companies and households have strong enough balance sheets to stay resilient in front of so many changing conditions. Time will tell.
Despite the war in Ukraine, the ECB kept an hawkish tone during its meeting and although the rates were left unchanged for now, the exit from the Asset Purchase Program will happen faster than expected.
For both Central Banks, inflation expectations were revised higher and GDP growth expectations lower, for this year.
The war in Ukraine, seems to be at its worst. Despite some progress in talks, and an apparent Russian withdrawal from Kyiv, the latest images of devastation from Bucha (a suburb of Kyiv) caused a fierce reaction from world leaders. Further sanctions could be imposed on Russia, and even Germany’s leaders, who opposed an energy ban until now because of the repercussions on their own economy, are considering banning Russian imports of gas. In the meantime, oil prices are evolving in the 100-120 USD range and are the main trigger for higher Consumer Price Indexes globally.
Among the different aid packages for Ukraine, the most significant one was the approval by the US congress of a $13.6 billion support bill. In the meantime, the generosity of the Americans has been well rewarded: the Biden administration has signed an agreement with the European Union which aims to boost the sale of US natural gas to European countries.
In China, a new Covid wave in the middle of the zero Covid policy brought further risk of delays in global supply chains since China is kind of the world’s main manufacturing engine. On top of that, Chinese credit is still vulnerable. Perhaps because of this economic deterioration, the Chinese government announced last month that it was done with the crackdown on techs and no new harsh regulations should disturb the companies from now on. Chinese tech companies’ stocks jumped by more than 40% on the news. The downside regarding this good news, is that regulations put in place last year continue to impact the companies’ growth and earnings…
There are certainly some threats looming above the financial markets and global economies, but we don’t see them as imminently dangerous. Therefore, for now we just stay invested, but hands on and ready to react. To paraphrase Jerome Powell “we need to be alert and nimble’.
As always, risk-management combined with rigorous sector and geographical diversification will remain key factors for investment performance.
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