Recession is NOT the issue for markets – inflation is, but disinflation is near
A reader of the Predictive Analytic Models (PAM) blog asked me the following questions:
Wouldn’t higher rates induce more potential market problems if the Fed increased in a downturn? Shouldn’t GDP potentially deteriorate after the third quarter?
(George Allen from New Yorkistan @geoallen66)
Mr. Tim Kaiser (Partner of PAM) remarked that this set of questions are exactly the same questions that investors are asking themselves and their financial advisors, given the very commendable performance of the stock market since the trough. of the June 16 market. Investors want to know if the good times can continue. If not, they want to know what can come instead.
It was also the same set of questions posed by the PAM community, which we addressed in several separate forums. But we continue to receive these requests. Therefore, we decided to structure the answer to these questions, including what we think is likely to happen next, in the longer term. Hence, this article Seeking Alpha.
The vexation of the recession
The market (SPX) is ahead of GDP variations by at least 1 quarter. In fact, the SPX has an impact on GDP instead of the other way around – the transmission is via looser/higher financial conditions and a positive CESI, with an increase in the SPX. The latest non-farm payroll data (June 2022) should ease the FC further.
Oh, there will be a recession as defined by NBER conventions, and the Q3 decline could be deeper than the initial Q2 estimate of -0.9%. Our proprietary GDP forecast model based on the historical relationship between changes in the 3y/10y yield curve and changes in GDP now shows a decline in GDP of -0.96 at the start of the third quarter (from the 07/08/2022, reference date Switzerland). The PAM GDP forecasting tool also showed -0.9 GDP in the latest BEA estimate.
Some of the estimates we’ve made using other tools suggest Q3 reading south of -2.00% Worse than Q2, cementing an official label of recession, but by no means a disaster. Experts are anticipating much worse, so if that’s all we get, then risk assets will do very well afterward, indeed.
That the FFR is increasing is not a surprise
The other thing that vexes the pundits is that the Fed will likely raise interest rates further in its bid to beat inflation. But it doesn’t matter if the fed funds rate will rise further. The FFR is a highly lagged variable – indeed, the Fed is significantly lagging the curve. It only affects market sentiment in the short term, but only enters the dynamics of inflation, in terms of its structure, a few months later.
During the latest FOMC Q&A session, there was a portion of Fed Chairman Jerome Powell’s responses to questions that seemed to indicate that the Fed Chairman was hinting at a possible pivot in the Fed from its quantitative tightening regime. But the market was wrong.
The Fed is ignoring the impact of the recession – that’s very clear. All the talking heads at the Fed have come out in recent days to underscore the Fed’s determination to defeat inflation. They cannot do this if financial conditions improve (eg, lower long-term yields, rising equities). That’s why this chorus of Fed speakers is trying to subvert the market’s impression of a Fed pivot.
That said, there is also a generally positive correlation between FFR and SPX.
The decline in the SPX is mainly due to the low total profitability of domestic enterprises (NIPA), and not to the rise in inflation.
Although retail investors mention FFR when discussing interest rates, this mental image is usually confused with the long-term bond rate, the 10-year yield. Therefore, the focus on *rates* usually and ultimately leads to questions about what the 10-year yield will do during a regime of rising fed funds rates.
Before the Fed launched quantitative easing in November 2008, the covariance between the FFR and the 10-year yield was probably negative, especially when monetary policy rates are rising. The lens of this relationship was the effect of the rise in the FFR on GDP growth (negative), and again arguably, the decline in GDP growth will likely be accompanied by a decline in the 10-year yield. However, after the start of QE, this negative covariance was reversed: the rise in the FFR now tends to push up the 10-year yield, with very short-term rates (proxy: repo rate (GC) as the transmission mechanism .
The day-to-day relationship between the 10-year yield and equity indices is generally positive, to the point that we take a positive covariance as a sign of a risk-taking mode for the day. The longer-term correlation between the 10-year yield and the SPX is also broadly positive. The best positive covariance is provided by a one-week lead of the 10-year yield. This is a historical, general relationship that has hardly changed in recent decades.
The punch of rising inflation is real but could be short-lived
Nevertheless, the lagged effect of inflation shows up in the multiples of the current PE, which tend to fall when the CPI goes above 4.00%, although inflation is a lagged variable. But it may be that the current low P/E simply indicates that SPX’s current valuation is low relative to earnings. For that, we may have to wait another week or so, until the current earnings picture is complete.
So, put simply, the problem is not declining GDP growth – equity and bond markets already discounted this months ago. The real concern is inflation, as it has a structural impact on the SPX (chart above). But market-derived data has now emphasized the potential for disinflation to come.
More importantly, the final demand PPI has already declined and is expected to fall significantly, or even collapse, over the coming months, as growth in all major contributors to the final demand PPI has sharply fall.
We’re going to start worrying about Fed and Treasury liquidity problems again
In a few days we will have the CPI data for July which has a high degree of certainty to be significantly lower than the June data. This of course removes the biggest bugaboo for the stock markets, at least in the medium term. Thereafter, market metrics will once again shift to systemic Fed and Treasury liquidity issues, as well as global government spending. The short term still looks problematic as overall Fed credit continues to roll. But that shouldn’t last.
However, the overview is constructive. Global equities and other risky assets are impacted by global government spending, but distributed lags are long (2.5 years). These key spending variables promise a better environment for equities through the rest of the year and into the first half of 2023.
On the one hand, it can be a short-lived lift. Risk asset prices in H2 2023 could be impacted by the lagged impact of lower government spending 2.5 years ago and the very weak economic conditions that were the direct cause of the curve inversion rates that we are currently seeing. We should see the negative impact of the current yield reversal on US GDP growth within 5-6 quarters, i.e. the end of 2023.
Unfortunately, the late 2023 weakness signaled by the 3-year/10-year yield curve will now coincide with the seasonality of global government spending outflows at that time, so risky assets will likely suffer a double whammy at the end of 2023 and part of 2024. . That’s to say RECESSION we should fear, not the declining growth garden variety we’re likely to see in Q2-Q3 2022.