Investment Newsletter – August 2023
The yield curve is very inverted today, usually indicating economic stagnation; however, stock market crashes and recessions do not usually occur until sometime after curve inversion happens, averaging around fifteen months. The curve inverted in July of 2022, fourteen months ago, implying we’re in a prime time for a recessionary crash. Most often, the yield curve rapidly steepens during the crash as the Federal Reserve reduces its interest rate outlook due to disinflation-created recessions. Long-term rates are comparably less sensitive to recessions than short-term rates driven by Federal Reserve management. However, despite historically high recession odds, the Fed is not keen on cutting rates, likely because fundamental inflation levels are well above their target.
The Philadelphia Fed GDPplus measure, a blend of GDP and GDI, is flashing a signal that recession has already started. The Fed’s latest Beige Book suggests the U.S. economy is slowing and consumers are growing more price sensitive, a potentially cautious sign for corporate earnings reports in the back half of this year. The Beige Book contained 15 references to recession, up from three in the July report, and that most districts reported higher delinquencies on consumer credit lines. While inflation expectations have remained stable and the job market largely resilient for now, Americans are growing more pessimistic about the economy.
Historically in inflationary recessions, nominal returns of stocks mask the true damage done to equity portfolios; bonds rise in nominal terms, but in real terms they start selling off long before the recession begins; and commodities don’t fall in price, they rally.
High positive gaps between earnings and bond yields have been extremely bullish for stocks and credit, citing March 2003, 2009 and 2020. By contrast, when the gap has turned negative, as in August 2000, or has narrowed to a low, like in July 2007, it has triggered “not so great” periods for these risk assets.
A stronger dollar adding to yuan pressure is an ongoing risk to liquidity in China and the rest of the world. The yuan fell versus the dollar overnight, with USDCNY nudging near 15-year highs. This is not something welcomed by Chinese policymakers, as evidenced by the gap between USDCNY and the official fixing at near- historical extremes.
Global money growth will remain under pressure while China refrains from comprehensive easing, posing a potential secular headwind for risk assets and economic growth around the world. Money makes the world go round. Nowhere is that more true than in markets. No money, no liquidity, no transactions. Any impediments to money are thus a big deal for asset prices and economies. Money has been in great abundance for most of the last 20 years. But that is in large part due to China. Its current travails therefore pose a significant risk to money’s path in the coming months and years.
