I still remember that day – it was sometime in 2007 – I was a young, aspiring private banker in the office of Citibank in Geneva, Switzerland. A dozen or so of us were gathering in Salon Leman on the 6th floor, where some of our best meeting rooms overlooking the lake were located. The topic: capital markets boot camp, a two-day intensive investment training for Citibank staff, led by a senior trader flown in from New York for the occasion.
Despite its name, Salon Leman did not face the lake, it faced the back of the building towards Rue du Rhone, Geneva’s main commercial street. But, from one of the side windows, you could still catch views of the Jet D’eau (Geneva’s iconic water feature) on a clear day. Good for daydreaming…
As it turned out, there would be very little time for daydreaming during our boot camp. Our speaker was witty and engaging, and would proceed to show us the proverbial ropes in a way only a hardened Wall Street veteran could. She had a no-nonsense approach and peppered her presentation with colorful anecdotes about everything from smoke-filled 80s trading floors to investing strategies favored by Japanese housewives.
But out of all topics covered, what stuck with me the most were her comments on bear markets and recessions. What she described was a monetary policy and interest rate pattern that preceded every bear market, without fail, each and every time: “an inverted yield curve,” she said. “And one final rate hike, one rate hike too many…chokes out the economy,” she added, making a strangling motion with her hand around her throat. “The yield curve gets inverted, then the recession hits…”
At that particular time in 2007, the yield curve had been dipping in and out of inversion (inversion simply means that bonds maturing in the short term had higher yields than bonds maturing further into the future, the opposite of what you would normally expect), and the federal reserve had been raising interest rates. Yet there was no talk of recession in the financial media and no signs of economic collapse. “This time is always different,” she told us, the popular explanation for the inverted yield curve at the time was that Chinese buyers had an insatiable appetite for long-dated treasury, keeping long-term interest rates down, and certainly not that we were heading into recession. “There’s always a story,” she said, sarcastically…
LAKE GENEVA (LAC LéMAN) IN
Within a few months of our boot camp, the episode now known as the Great Financial Crisis would begin to unfold. A recession so severe that my former employer, one of the largest banks in the world, nearly went bankrupt.
Today, Citibank no longer occupies the lakefront building in Geneva, and my former colleagues have been relocated to a more functional location on the other side of rue du Rhone, minus the lake views.
What, if anything, is a Recession?
I’ve since had plenty of time to reflect on the lessons from that day, and 2022 has offered yet another opportunity to ponder its wisdom. For most of the year, comparing the 2-year yield to the 10-year yield would have shown clear inversion (2-year yields higher than 10-year yields), and the Federal Reserve has been raising rates faster than any time in recent history. With these factors in place, it would seem like stars perfectly aligned for the start of a dreaded recession.
Depending on how one defines recession, it may in fact have already happened. With negative annual growth numbers in Q1 and Q2, 2022 delivered the often cited “two consecutive quarters of negative growth” that constitutes a recession in the mind of many. By that definition, we are either in a recession or just coming out of it.
Indeed, the word “recession” has grabbed headlines all over the world. If Google searches are any indication, it also occupied mind-shares like never before, even more than it did during the 2008 crisis, or the height of COVID lockdowns.
Judging by this apparent recession mania, one might imagine a world engulfed in the depth of a devastating recession. Yet, if this is indeed a recession, it certainly does not feel like one.
The hallmark of a recession, to my mind anyway, involves hardship among the general population, rising poverty, and weakness in the job market in particular.
Yet a photo from the 1930s Great Depression could hardly be more different from what we are seeing today, not only because of how incredibly well-dressed unemployed people were in the 1930s, but also because there simply isn’t any form of employment or income crisis in the US currently.
While some layoffs in grossly overstaffed tech firms have been making headlines, the reality on the ground for most businesses is still that of a labor shortage: a struggle to find enough workers.(1)
While much has been made about declining real (inflation-adjusted) wages, a closer look at income data (Figure 1.C) indicates that keeping up with inflation in this red-hot job market requires one simple step: switching jobs. Indicating that lagging wage growth has had more to do with payroll inertia than anything else.
To be sure, despite strength in the labor market, more bearishly-inclined observers may point to various softer pieces of data, including ISM manufacturing PMI (a survey of 400 industrial companies) which has now declined below 50, indicating anticipated decline in purchasing activity.
Yet once again, growing employment trends appear disconnected from negative survey results, begging the question: if manufacturers anticipate slower activity, why do they keep hiring?
Historically, disconnects between employment data and the more volatile survey results tend to resolve themselves with PMI data catching up to the reality of hiring activity. In other words, watch what companies do, not what they say.
Economic growth returned in Q3 with real GDP increasing by 2.9%, while companies continued to deliver strong results. Whichever way you look at it, the dreaded recession, so far, has failed to materialize. Setting aside news headlines, one might even conclude that as we enter 2023, the US economy isn’t actually slowing, but accelerating.(2)
Never go full VolckerMuch of the continued recession fears boil down to well-founded expectations that the Federal Reserve may hurt the economy with excessive monetary tightening. The pace of rate increases even prompted some observers to suggest that Fed chairman Jerome Powell had “gone full Volcker” a reference to Paul Volcker, the 1980s Fed chairman renowned for bringing rampant 1970s inflation under control.(3) Yet, current monetary policy is a far cry from anything resembling the early 1980s. During Volcker’s tenure, the US experienced the longest period of 5%+ real (inflation-adjusted) interest rates recorded in the post-war era. In contrast, despite all the noise and commotion, the current level of nominal interest rate is still well below inflation levels, and is actually one of the most deeply negative real interest rate environments ever recorded. Against this backdrop, it’s unclear what the current Federal Reserve leadership has done to deserve any comparison with their 80s counterparts. This did not stop public opinion from turning strongly against central bank actions, and a chorus of voices ranging from Elon Musk to the United Nations rang the alarm bell.
This time won’t be different
Where is the recession then? And what should investors make of the deeply inverted yield curve? And did I, after all these years, forget the lessons of my strikingly prescient 2007 teacher?
The current level of yield curve inversion sends an ominous signal. Not only is it inverted, but the depth and breadth of inversion has reached levels that have always been associated with recession in the past. This time is unlikely to be different.
In data going back to 1987, the American Association of Individual Investors has never before recorded 36 consecutive weeks of negative investors sentiments, 2022 is setting a new record.
Bearishness isn’t limited to individual investors either. In a recent Bank of America survey of mutual fund managers, the level of “underweight” equity” sentiment has reached levels consistent with extreme market lows (as happened during COVID and the 2008 crisis): With extreme bearish positioning and sentiments, it’s worth remembering that predicting a recession and making money from that prediction are two very different things. A quick review of market performances immediately following prior instances of yield curve inversion shows that, on average, stock investors do surprisingly well in the months following inversion.
For what it’s worth, a naive speculative strategy involving a bet against the stock market in July 2022, when the curve first inverted, would have yielded negative returns thus far.
As history has shown repeatedly, investors are prone to herd behaviors both on the upside (buying into a frenzy) and downside (selling into a panic). While the transition away from years of unfettered money supply growth and low-interest rate will almost certainly involve recessionary periods (consistent with the yield curve signal), it’s worth remembering that there is no blueprint, no guidebook, to tell when it will start, how deep it will be, and what path markets might take leading up to it, or coming out of it.
Can we just move on?
While most of this year’s market commentaries have almost uniformly focused on the narrative of an excessively aggressive Fed destroying the economy, I believe a much different reality is taking shape as we enter 2023. In fact, many indicators suggest that the economy has remained stubbornly strong, and while the shift in central bank policy may seem scary, it is really not that dramatic when considered in the broader context. With inflation still running at 7.1%, and the Fed’s predicted “terminal rate” (the peak of its current rate rise plan) estimated at 4.75%, current policies still only make sense under the assumption of normalized inflation levels in the coming months. As for measures of broad money supply, they are still a long way away from what would be considered “normal” by any historical standard, even after recent balance sheet reduction efforts.
On the bright side, there are early signs that some of the high single-digit inflation readings of early 2022 may be starting to cool. However, as we have seen, continued strength in wage and consumer activity means that price pressures are likely to continue. From that perspective, the hope of a pivot in Fed policy may only materialize in the form of a short reprieve.
A strong consensus view has emerged around the idea that the Federal Reserve is aggressively normalizing its policy, that the recession has started, and that the next few months will now simply determine how bad things get (soft vs. hard landing). Reality, in my opinion, is much worse: there is no recession, and the Fed has not normalized its policy.
What makes this state of affairs much worse is that markets must still contend with what comes next. If this isn’t a recession, then what is? If this isn’t a normalized monetary policy, then what will normalization really look like?
Perhaps the obsessively negative mood we currently observe captures more than just recession fear. It captures the hope of a clean transition back to some form of an old normal, a way to move on: one more bout of policy tightening, one more leg down in the market sell-off, an orderly drop in corporate earnings, perhaps a few quarters of negative growth in early 2023, followed by a rebound, and a new upward trend, a sort of economic reset button. To be sure, It may very well happen that way. But as we enter 2023, the economy is still grappling with the consequences of years of monetary and fiscal largess: we’re enjoying its benefits in the form of renewed job market vigor and its increasingly intolerable costs (elevated inflation), as well as distorted markets.
We are still in the midst of the greatest monetary policy experiment of the modern central banking era, and 2022 has, at best, offered hints of what a possible resolution may eventually look like. Hopes of a clean transition out of the current regime, of an economic and monetary reset, are unlikely to materialize. Given the scale of past excesses, investors should brace for the long and winding road ahead toward anything resembling “normalization.” In all likelihood, it will involve repeated see-sawing between varying degrees of monetary tightening and loosening, and a heavy dose of fiscal policy attempting to even the playing field. From that point of view, 2023 may only mark the beginning of the process. And as much as we’d like to, we can’t just move on.
ABOUT THE AUTHOR
Syl Michelin, CFA
US EXPAT FINANCIAL ADVISOR
Syl Michelin is a Chartered Financial Analyst and fee-only, fiduciary financial advisor who works with cross-border families and American expatriates.