Does the recession have to mean a bear market on the stock exchange?

by independenttrader

When in 2017, we have begun to mention the upcoming US-China trade war, the largest media have not yet been interested in this topic. The situation has changed a year later, when the tariffs imposed by Washington has dominated the headlines. Trade war and its negotiations have become a convenient subject explaining all changes on the markets.

Everything indicates that we are experiencing a similar pattern in the event of an upcoming recession. Last Friday we were dealing with the reversal of the yield curve in the United States. This is a situation where the interest rate on short-term bonds is higher than in the case of long-term bonds. Last week, the yields of 3-month and 1-year US bonds turned out to be higher than 10 year yield. Such a phenomenon is usually treated as a signal of an impending recession.

As in the case of the trade war, mainstream media needed a strong impulse, a specific event to inform that the recession is on the horizon. When the yield curve started to reverse at a rapid pace, markets suddenly became paralyzed by the fear of the upcoming recession. Meanwhile, from the investor’s perspective, such information is belated and of a lower value.

Therefore, we will take two steps forward again – we will check whether the economic data also indicates a slowdown and we will consider whether the recession must mean the bear market appearance on the trading floors. Ultimately, during these times central banks are trying to keep the market away from panicking.

 

Treasury Yield Curve

Let’s first begin first with the US bond market. As part of a small reminder – most of the time, bond yields are higher, the longer their maturity. Ultimately, lending money for a longer period of time bears higher risk.

However, this does not change the fact that sometimes, the demand for long-term (10 or 30 years) US bonds is so large that their yields drops and are lower than in case of the short-term bonds. Such a phenomenon generally means an increase fear among investors. As a result, there is a reversal of the yield curve, which can be seen on the left on the graph. The light gray color shows the yield curve from two years ago, the dark gray one – from the last year and the blue one – current situation. As you can see, the latter no longer shows the growing trend (like the other two), but slowly begins to turn.

In turn, on the right side of the graphic is a chart showing the difference between the interest rates of 1-year and 10-year US bonds. When the spread falls to zero (as it is now), it indicates an upcoming recession. This indicator has worked well for the last 7 recessions.

Anyway, the details from the bond market do not have to immediately convince anyone that the recession is on its way and you must run to the safest assets. Furthermore, many analysts responsible for maintaining “good moods” have already managed to say that this time the market reacts differently and one should not worry about the yield curve. The more it is worth to look at other important indicators.

 

Global Weekly Leading Index

Observation of the GDP of various countries allows us to state that we are dealing with recession. However, there is a so-called leading indicator that monitors changes in many macroeconomic data (including GDP, sales, employment). When its value in annual terms begins to drop, it should be treated as a significant warning. Not every descent below zero means a recession, but in the current situation a glance at the graph tells us a lot. Global Weekly Index is today almost 3% lower than last year.

What will happen to the index in the coming months? Nobody will answer this question, but we can look for clues analyzing the situation in different regions of the world.

 

ASIA

Let’s begin with a country which for several decades has had a huge impact on the economic growth rate all over the world. A lot depends on China, while the local industry informs that the country experiences lower and lower demand for their products. The below PMI index last time was so bad at the bottom of the recession in 2009.

Official figures for China still shows economic growth at 6%, while statements suggesting it is rather 0 or 1% are immediately censored.

The exports of South Korea also look dramatic. As we have just mentioned, this is an indicator that should not be disregarded, because it often works as a reflection of the global economic conditions (and future profits of companies) . Currently, export of South Korea falls every month. In February, it was a decrease of 11.5% compared to the same month a year earlier. In turn, the result for the period 1-20 march is a decrease by a further 5%.

There are also areas in the industrial sector where incoming orders for Asian products are 30-40% lower than a year ago.

 

Europe

Manufacturing PMI in the euro area speaks for itself.


Source: tradingeconomics.com

As a reminder – above 50 indicates growth and below 50 means the economic sector’s contraction (in nominal terms, without inflation). Now European industry is below the key level.

In addition, the services PMI looks better and amounts to over 50. On the other hand, it is an indicator that reacts with a slight delay to the manufacturing PMI and generally behaves more gently (i.e. does not adopt such extreme values as manufacturing PMI).

There is nothing to be excited by data from Italy, which has been in the economic downturn for a long time. The real problem to worry though are the signals from Germany. In this case, we can already talk about entering recession, and yet it is probably the most important economy on the continent. Germany among others suffers due to the deteriorating situation in the automotive sector, which is usually one of the first to be affected by the weakening consumption demand.

In many euro area countries GDP growth is below 1% per annum, while the unemployment rate is low compared to the historical data. This situation creates a pressure on employers to raise wages. This, in turn, increases the cost of goods and services. Prices are rising, and consumers have less and less financial opportunities.

The scale of danger is also showing in the bond market. German 10 year bond yield has dropped below zero last week. In other words: people are looking for a safe haven for their funds and choose government bonds, even if they guarantee loss.

 

USA

After FED has resigned from the regular interest rate hikes in January, there has been a slight easing in place. And again we have seen the stock market rally, optimism has returned, and Donald Trump could once again proclaim that the American economy looks great and would look even better if interest rate hikes has not hapened before.

The problem is in the US economy which reached a certain level and there are problems related to its overheating. The first example is labor costs, which are measured, among others, by a special organization associating small entrepreneurs. So far, every time their index reached around 8-10 points, the recession has hit the US the next year at the latest.


Source: bloomberg

Also famous, record low unemployment in the US, is slowly growing. In effect the average unemployment rate for the last 3 months is higher than for the last six months. Over last few decades, every such type of event has preceded a recession.

As for GDP growth in the US, the first quarter of 2019 will still be positive. It can, however, negatively surprise the market. Many large entities assess that GDP will be between 1.5% and 2.5%. On the other hand, much more calm and credible in its forecasts, the FED from Atlanta forecasts from 0.2% to 1.2%. Needless to say, GDP far below forecasts will mean hundreds of news about the recession and further shocks in the market.

Let’s not forget about the FED statement from March. The total exclusion of any rate hikes this year, fairy tales about a rate hike next year and premature termination of the balance sheet reduction. This means that the Federal Reserve is already preparing for the first hit of the recession, after which tools of exceptionally loose monetary policy will be automatically applied.

 

Canada

Data for the last quarter of 2018 shows that the Canadian economy practically stood still. Overall, the economic growth for the previous year was 0.4%.

It has to be noted that in this country a key role plays the real estate market. The inflow of Chinese capital and speculative activities have been raising housing prices to the record levels, which we have mentioned several times before. As a result, the value of real estate and activities related to this market (e.g. construction, insurance) have started to have a huge impact on GDP. At the same time, flats and houses became inaccessible to the ordinary citizens of Canada, what caused considerable dissatisfaction. The society protests over time have brought desired results. Vancouver and Toronto have decided to introduce special property taxes for real estate purchased by foreigners. In this way, the market was cut off from the new capital and the bubble began to burst, which now translates into worse macroeconomic data.

In order to make you aware of the scale of the bubble in Canada, we will make a small comparison. Perhaps some of you have heard about the incredible high prices of real estate in San Francisco, where even high earners like programmers have a problem with buying a flat. Now let’s compare the increases in real estate price indexes in San Francisco and several Canadian cities since January 2002:

– San Francisco Case Shiller Index increased by 121%,

– Montreal Bank House Price Index increased by 158%,

– Toronto Bank House Price Index increased by 205%,

– Vancouver Bank House Price Index increased by 300%.

This gives a certain point of reference how dramatic effects on the Canadian economy may have a bursting bubble in the real estate market.

And now one important point: After World War II, the United States fell into recession, and Canada was able to avoid it. In turn, when Canada fell into recession – the United States always fell into it.

In summary, the situation in Europe, Canada and Asia looks very poor. In case of the United States, inferior data just makes themselves known.

 

Does that mean sharp drop in the stock market?

We will certainly be witnessing events similar to those from last Friday. Sharp drops in share prices and strong increases in bond prices. It is much harder to say in what scale they will be.

When central banks have started purchasing shares and bonds 10 years ago, the market did not know what the effects of these actions might be. Today, thousands of investors believe that the appropriate scale of purchases has the chance to keep the assets at high levels. This is one of the factors that supports optimism in the US. In this way, the FED has led to an absurd situation in which the market prices completely dispersed with expected profits of the companies. This can be seen in the chart below, where the S&P 500 index is shown in green, and the profits of the companies included in the index are denoted as a red line.


Source: zerohedge.com

The last decade in Japan could be a measure of what can happen to the stock market with shrinking economy and central bank interventions. Purchases of the Bank of Japan have made the stocks growing despite today’s dramatic conditions of its economy, and today they are significantly above the peaks of 2007:


Source: stockcharts.com

However, until the recession is officially confirmed central banks of US and China, have no pretext to introduce gigantic printing and negative interest rates. When that happens and the bankers confirm their announcements, more events will be likely to be assessed. Up to now, two opposing forces will act on the stock market.

On the one hand, fear of recession and information about companies’ poor results will deter from investing in shares.

On the other hand, hope of imminent printing launch will cause some investors sitting on the market to take advantage of the first strong rebound after the announcement of the printing.

Donald Trump has a strong motivation to keep high prices on the stock exchanges. The better the quotes, the more Americans in a good mood will approach the next year’s elections.

 

Summary

With the current involvement of central banks, it is extremely difficult to determine where the markets will be in the next three months. However, we are convinced that another bad data coming from the economy will sometimes increase volatility in the markets.

Central banks will certainly try to save the situation. However, one can not rule out a scenario in which one of their interventions will be perceived by the market as a total loss of control over events. What will happen then? In a moderately pessimistic scenario, the stock market will be massively shaken, capital will flow to bonds. In an extremely pessimistic scenario (very low probability), capital will start to evacuate from both main markets which could be a threat to the further functioning of the financial system.

In our opinion, the most likely scenario is a printing on two fronts. On the one hand, we mean keeping high prices on the stock markets to avoid panic. On the other hand, the economic recession will lead to a strong rise in unemployment. Governments will be forced to spend more on benefits, some countries will bring guaranteed income. In the context of the markets, the result will be a repeat from the 70s. High inflation and increases in tangible assets prices. Extremely expensive shares in the US in nominal terms will fall in the sideline trend or slightly increase, but after taking inflation into account it will turn out that they were hopeless, and only bonds performance were worse than them.

However, before central banks officially face the recession, it is worth to hold your funds mainly in cash. The best in US dollar and Swiss franc, i.e. safe haven currencies.

 

Independent Trader Team

 

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