Why are markets acting as though the U.S. is about to enter another recession? Because the officials who manage monetary and credit policy are widely believed to be taking us into negative economic growth in order to fight the inflation that the same group has brought upon us. Why is that widely believed? Because inflation remains stubbornly high and that reflects badly on the people who caused that to happen. Why has inflation been so high? Because those same government officials vastly increased money supply during the COVID shutdowns. Why did they do that? Because the shutdowns caused a deep depression and the central planners wanted to lessen the pain of that depression.
We see mistakes by government in response to the effects of other mistakes by government. Frederick Hayek called this the “road to serfdom,” government interventions based on the “fatal conceit.” The “conceit” (i.e. pride) is the belief that expertise is better than adherence to simple but permanent principles. The experts intervene, creating a crisis, and then they intervene again to deal with the crisis they created, and so the interventions, and the crises, pile up.
But what if our rulers had followed Biblical principles, for example when it comes to dealing with contagions? The Bible quarantines the sick, not the well (Leviticus 13). Without broad, extended government shutdowns of the economy, we would not have had such a complete economic collapse. The experience of past pandemics shows that. Without such a collapse, there would have been no rationalization to vastly multiply the money supply, violating the Biblical commands about just weights and measures (This economic trend is an abomination). And without that debasement, we would not have had the inflation, and without the inflation we would not now have a set of policies which are likely to trigger recession. The pain now is due to the foolish policies which came before. The Bible has it right: “The compassion of the wicked is cruel.”
Big Picture: It’s important to remember that the Fed is by far the largest actor in U.S. financial markets. No other single actor is close in scale to the Fed’s 10 trillion dollar portfolio of financial assets (mostly bonds). It’s also important to remember that the economic model employed by the Fed presupposes that there is a trade-off between inflation and recession. The tool to avoid (or escape from) a recession is believed to be inflation. Of course, it’s not said so crassly; instead it’s described as “monetary stimulus” or “stimulating demand”, but what that means is that the government injects excess money into the economy, which discourages savings (because inflation causes savings to lose purchasing power), and therefore encourages spending. That’s a pro-inflation point of view, and it has policy makers who have championed it. In fact, the pro-inflation/anti-recession mandate came from members of Congress who held the view that the Fed should stop focusing only on fighting inflation, but should sometimes use inflation to avoid recession.
There is also a pro-recession/anti-inflation faction. That faction believes that inflation is caused by excess growth, which is described often as “overheating”, as though the economy is like the motor of a car which heats up at high speeds. That faction therefore believes that the Fed must slow down the economy to fight inflation in order to (as one former Fed chairman said) “take away the punch bowl once the party gets to be too much fun”. Of course, when the Fed intentionally slows down the economy, it knows that it’s risking a recession. Historically, when the Fed has embarked on punch-bowl removal tactics, it generally has led to recession, so, of course, they know that monetary tightening is reasonably likely to lead to a recession. Plus, the behavior of markets during this current tightening cycle is clearly indicating that investors think a recession is coming, as do most economists. So, bottom line, the punch-bowl snatchers certainly know that their policy is likely to cause a recession. They’d never say it that way, but that makes them pro-recession.
It’s not that the inflation faction thinks inflation is good. Rather, they think inflation is better than recession, so they opt for inflation. It’s not that the recession faction thinks recessions are desirable: they just think recessions are more desirable than inflation, so they choose recession.
Every day, information is evaluated by investors who ask of each piece of news: “Will this strengthen the inflation faction or will it strengthen the recession faction?” Last week, investors concluded that the news strengthened the recession faction, so they moved closer to pricing in a higher probability of recession and a lower probability of inflation.
Last week, the news events driving markets were an unexpectedly strong survey of supply chain managers in the service sector. If the economy is stronger than expected, the recession faction can say, “it’s okay if we contract the money supply and slow things down in order to fight inflation, the economy can handle it.” There were a few other better-than-expected pieces of news: durable goods orders, factory orders, and the widely-followed consumer sentiment survey beat expectations. But the big item of the week was probably the fact that wholesale price inflation was higher than expected. That gave further support to the recession faction, because if inflation is worse than we thought, we need to tighten money supply to fight it, even if that means triggering a recession.
So, the typical hawk (i.e. the recession faction) pattern of trading occurred:
- The futures market shifter slighted toward expectations of bigger hikes.
- The CME (Chicago Mercantile Exchange) Fed Watch Tool shifted in such a way as to imply that if the predictions of future hikes turned out to be wrong, the hikes would more likely be larger than expected rather than smaller.
- The dollar rose.
- Inflation hedges lagged non-inflation hedged investments.
- Markets in general fell.
Let’s look a little more closely at the two metrics that use the futures market to predict Fed activity. One is called the WIRP report and is based on one particular model of using options to predict future rates. But there is another model, the CME Fed Watch Tool that we mentioned above, which focuses not so much on what the future rate will be, but rather on how probable that outcome is. The WIRP tells us what the market expects the rate to be. The CME tells us how probable that outcome is and whether the risk that the prediction is wrong is to upside or to the downside. The WIRP showed higher-than-expected rate hikes over the next year. And the CME report showed that if the WIRP is wrong, the real hikes will probably be higher than the predictions, not lower. In our view, that amounts to two big data points in favor of the hawkish trade.
Sometimes a shift in expectations about future Fed policy also creates a shift in expectations about future growth prospects. In other words, often if there is a shift towards belief the Fed is going to be tighter, that shift is accompanied by anti-growth trades. This occurs because investors think the tightening of monetary policy might cause the economy to slow down. So, although hawkish shifts don’t necessarily always coincide with anti-growth trades, they usually do. That makes sense, because that’s what hawkish policy is designed to do, to slow the economy in order to cool price inflation down.
Last week followed the pattern, the trades between broad asset classes were generally anti-growth:
- Stocks were negative.
- Bonds were negative.
- Stocks were more negative than bonds.
- The dollar rose.
- U.S. Stocks underperformed global stocks.
- Generally commodity indices fell.
So, last week fit the hawk flight pattern, and the trades between asset classes (stocks vs. bonds vs. commodities vs. real estate vs. currencies), saw that as tilting the U.S. towards recession.
As we shall see in the detail below, the hawkish pattern also appeared in the comparative returns within asset classes (e.g. one sector of stocks vs. another; one class of bonds vs. another, etc.). And the variations between sectors sent pessimistic signals about growth.
Next week, the big item is the Fed meeting itself. They’ll announce the new policy (probably a hike of .5%), and there will be some commentary from the Chairman, which investors will pour over trying to read some hint of what to expect in the future.
Bond Market Last Week: Stocks significantly underperformed bonds, which constitutes an anti-growth signal. In addition, variations within the various types of bonds were generally sending anti-growth and anti-inflation signals.
Bond markets were generally down last week, which fits the narrative of a tougher Fed. After all, if the Fed is going to be selling more bonds (or at the very least buying fewer bonds), it’s no surprise for bond investors to see that as bad news for that asset class. The macro-economic implications of that expected shift in policy become clearer by taking a higher-resolution look at the data, turning the magnification level up to see how different types of bonds reacted.
Treasury bonds, the ultimate safety play, overperformed high-credit-quality corporate bonds, which are considered a little riskier. Low-credit-quality corporate bonds lagged high-credit-quality ones. So the riskier the bonds, the worse the performance.
That makes sense when recession risks are seen as rising: when business slows down, companies find it harder to make their debt payments, but the government can always tax or print more. So, corporate bonds are more likely to default and forward-looking investors sell them now rather than risk being left holding the bag if a company defaults on its debt service payments. Last week, markets acted as though growth might not be high enough for well-financed corporations to make those payments. That’s called ‘risk off’.
Switching from the growth to the inflation topic, inflation-protected securities performed poorly compared to their non-inflation protected alternatives. That implies less fear of inflation. Because if investors sell inflation hedges more aggressively than the alternatives, it is logical to consider it likely they are less worried about inflation. That also fits the hawk/recession trade: if the Fed revs up the fight against inflation, we’ll probably get less inflation.
Real Estate Last Week: REITS performed negatively. REITs have a slight tendency to perform between stocks and bonds, because real estate has some of the characteristics of stocks (such as a growth upside), and some of the characteristics of bonds in that the income source for real estate is leases and leases are bond-like, involving fixed payments.
U.S. Stock Market Last Week: Domestic equity markets were generally down last week, but not equally so. Growth stocks lagged value stocks across size categories.
Growth tends to beat value when growth expectations are rising, because low growth presumably makes it harder for earnings to actually deliver on growth companies’ high expectations. So, the weak growth performance is consistent with the anti-growth trades. That is indeed likely, because the pattern last week showed a pretty consistent anti-growth signal.
On the other hand, the weak performance of growth stocks might have been driven by rising interest rates. Growth stocks are more dependent on low interest rates than value stocks, so consequently, they also tend to underperform value stocks when interest rate expectations are rising. Their long time horizon causes the discounting effect of interest rates to play out over a longer period of expected future earnings. Whatever the interest rate expectations, whether higher or lower, they tend to have a larger effect when it is applied over a more years of discounting. Since growth stocks value are based on a longer time horizon, they tend to fluctuate more in response to interest rate expectations about the future. The value-expanding effect of low rates helps companies whose investment premise is based on the long view more than those whose investment premise is based on the short view. Since last week was about a shift towards higher rate expectations, it’s no surprise that growth lagged value. That’s what basic theory and history would teach us to expect.
It’s honestly hard to know how much last week’s growth-vs.-value performance was about the Fed changing the valuation of stocks by changing the interest rate, or about the Fed triggering a recession. Causing a recession implies future cash flows will be lower. Raising interest rates means that future cash flows will be discounted more deeply. Both of those things hit growth stocks.
But if one looks at the difference in performance between different stock sectors: S&P/NASDAQ, cyclical/defensive, discretionary/staples, and discretionary/utilities, one sees a pretty consistent anti-growth trade. Plus, last week interest rate expectations only rose a small amount. All this suggests domestic stock performance last week is more about the rising probability of a recession than it is about the discounting effects of rising rates. In other words, it’s more a recession warning.
International Stock Markets Last Week: International equity markets were mixed for the week. In general, U.S. lagged global stock markets in price returns. This occurred partly despite a falling dollar. In other words, foreign markets generally performed better than U.S. markets, even though their currencies generally performed worse than the dollar.
That fits with the idea that markets are continuing to back-off from the expectation that the U.S. will be a refuge from the global recession. For most of the year, markets have signaled that the U.S. might avoid the global recession, but so far this quarter, including the last couple of weeks, markets have been less confident of that.
In addition, developed markets were generally negative but emerging markets were generally slightly positive. However, when one zooms in closer, there were wide variations in returns last week based on region. EM Asia was quite negative compared to other regions. Typically, a hawk trade would hit EM hardest and so would an anti-growth trade. So, theoretically, it was a bad environment for EM and yet EM overperformed. It may just that EM has gotten so beaten up this year that the low valuation became enticing to bargain hunters.
Jerry Bowyer is financial economist, president of Bowyer Research, and author of “The Maker Versus the Takers: What Jesus Really Said About Social Justice and Economics.”