Markets Are Pricing in Recession
The S&P 500 Index was down almost 10% for the year after a further bout of selling on 20 January; the VIX Index has doubled; credit spreads have widened; and the price of oil has shed $10/bbl, some 27%, since the New Year fireworks went quiet.
In short, a number of markets are now pricing in an economic slowdown in the U.S., if not an outright recession. Based on our evaluation of the economic data we maintain the view that the real risk of a recession is not particularly significant—but such bearishness inevitably sends one back to check the thesis.
Markets seem to have been hit by a confluence of three factors: the slowdown and market uncertainty in China; having to digest the Fed’s first rate hike for a decade; and, especially, the collapsing oil price. Momentum has taken over from there.
The Economy is Slowing, But Not Worryingly
China is undoubtedly slowing, but we do not think there is significant risk of economic collapse and we would caution against reading too much into recent equity market volatility, which seems to bear little relation to what is happening in the underlying economy. The Fed may currently be predicting another three rate hikes for 2016 but we think the actual trajectory will be much more gradual than that. If we get something more like what is currently priced into futures, this would be unlikely to disrupt the modest economic growth that we anticipate. On oil, the concern is that sub-$30/bbl prices are telling us something worrying about the state of global demand—whereas we remain steadfast in our view that this is predominately a symptom of oversupply. It’s also important to note the significant benefit to the global consumer from lower oil prices, and the support this lends to the broader economy.
There’s no question that recent U.S. data in areas such as housing starts, retail sales, manufacturing production and inflation has been softening, and this has increased the risk of recession somewhat. There is a recessionary feel to U.S. industrial sectors, for example, where the strong dollar and the weakness in the energy complex have suppressed capex. We are certainly monitoring dollar strength and widening credit spreads, which can be associated with recessionary environment.
But, in our view, the broader picture is much more benign: the vast majority of U.S. economic indicators point to a continuation of recent gradual expansion. And while a sell-off in financial markets can feed through into the underlying economy by damaging consumer and business confidence—certainly a risk if this rout continues—we tend to think that the link between what the market is doing and the way consumers feel is a lot weaker than is sometimes supposed.
ECB Buys Time During Volatility, We See An Opportunity to Buy Risk
It was interesting to note the President of the European Central Bank, Mario Draghi, articulated a similar view in the press conference following the Bank’s monetary policy decision on 21 January. He was keen to emphasise that he “expects the economic recovery to proceed” and made the point that lower oil prices were effectively a stimulus in Europe. In addition he pointed to the impact that the ECB’s current stimulus program has been having, particularly on broad money growth and loan dynamics. He acknowledged that the slowdown in the emerging world and “volatile financial markets” might require the ECB to “reconsider” its policy stance in early March, but this sounded like the classic Draghi approach of saying that the ECB is ready to act in order to buy enough time so that, ultimately, it does not have to act at all. Sure enough, risk assets liked what they heard and the euro weakened.
We, too, remain persuaded that it’s likely a matter of time before markets re-focus on economic fundamentals. For that reason, we believe that current volatility and weakness presents an opportune time to consider increasing weightings in risk assets.