If recession is inevitable, how will global asset classes fluctuate?

Last Thursday (November 10), on the same day that the US inflation data for October "came out" - a larger-than-expected retreat, a little-noticed phenomenon was that a favorite recession forecast indicator of Fed Chairman Jerome Powell also sounded the alarm completely.

The so-called near-term forward spread curve — which tracks the difference between the 18-month forward expected yield on 3-month U.S. Treasury bills and the current yield — fell to -14 basis points on Thursday, inverting for the first time since the outbreak of the pandemic in the United States in early 2020.

Powell's comments earlier this year increased investors' focus on the curve. He made it clear that an inverted yield curve "means the Fed will cut interest rates, which means a weak economy." A 2018 Fed research paper first highlighted the importance of this forward curve, which is more reliable than the traditional yield curve in predicting recessions.

In any case, this "Powell curve" may be a milestone: because it means that almost all forward indicators of the bond market, which reflect the risk of a recession in the United States, have now sounded the alarm of recession.

Is a recession inevitable?

Before that, the rest of the yield curve had already inverted – whether it was the 2-year/10-year spread, which investors were most concerned about, or the 3-month/10-year spread, which the New York Fed most often mentioned.

All these inverted yield curves clearly represent one thing: a US recession may be inevitable!

Based on a comprehensive assessment of a series of recession models, the economic model built last month by Bloomberg economists Anna Wong and Eliza Wenger predicted that the probability of a recession in the United States in the next 12 months is as high as 100%.

The potential weakening of the economy has actually been reflected in the sharp layoffs and cuts in expenses of companies.

According to a CEO survey released last month by the Conference Federation and others, 98% of CEOs of U.S. companies said they were "preparing for a recession" when it came to the outlook for the U.S. economy over the next 12-18 months.

While the Conference Federation said the recession could be "short-term and mild," the U.S. economy is still likely to experience "stagflation" next year — that is, high inflation and slowing economic growth.

In fact, since the outbreak of the new crown epidemic, the US economy has been oscillating between "stagnation" and "inflation" due to the supply shock to the global supply chain. In order to cope with the "stagnation" in the early stage, the US government and the Federal Reserve did not hesitate to "release water" like never before, resulting in obvious excessive fiscal and monetary policies to stimulate demand.

And this year, in order to cope with the sequelae of easing policy - "inflation", the Fed had to raise interest rates at the most aggressive pace in 40 years.

Now, although the US CPI data has finally shaken off the "8 era", it remains to be seen whether the Fed can completely cool inflation. At the same time, the risk of economic stagnation has become increasingly magnified, and the risk of recession has become "dark clouds"...

How long is the current U.S. recession likely to last?

If a U.S. recession is really inevitable in the next two years, there will undoubtedly be a number of questions: For example, how long will the current recession cycle last? How will global asset classes fluctuate?

Generally, the official determination of a recession in the United States is made by the National Bureau of Economic Research (NBER). The economic recession defined by NBER is mainly manifested as continuous negative growth of real GDP, a sharp increase in unemployment, a decrease in real personal income, a weakening of real personal consumption expenditure, a continuous decline in industrial production, and a decline in social retail sales.

In the first half of this year, US GDP had negative growth for two consecutive quarters, indicating that the economy had fallen into a "technical recession", but when NBER officials defined recession, GDP was clearly not the only determining factor. From the current point of view, the decline of the US economy is mainly reflected in the weakening of consumption and production, but the overall job market is still relatively hot, which may not fully meet the criteria for judging a recession.

However, economists polled by the media now widely expect the US labor market to weaken in the coming months and even years – they expect the unemployment rate to rise from the current 3.7% to 4.3% by June 2023, the average forecast for the end of next year is 4.7%, and the unemployment rate is expected to remain roughly at this level through 2024. This suggests that the Fed's tightening efforts to reduce inflation will cause pain to workers.

Overall, the average forecast of economists surveyed by US media indicates that the current round of US recession is most likely to occur in the second half of next year, and the recession will last relatively short. Among economists who believe there is a greater than 50 percent chance of a recession next year, the average expectation for a recession to last is eight months.

By comparison, the average duration of a post-World War II U.S. recession was 10.2 months.

Take stock of historical periods of U.S. recession

Looking back at history, since the 70s, the United States has experienced a total of 7 recessions defined by the NBER.

If a fall in GDP of more than 3% is defined as a deep recession and less than 3% is considered a mild recession, then there are three deep recessions in total – 1973, 2007 and 2020, and four mild recessions – 1980, 1981, 1990 and 2001.

Here's a look back at the last five U.S. recessions:

1980-1982 (mild recession)

The reason why we want to start with the recession in the 80s is because it is actually the most similar recession period to the current economic situation - the US CPI has updated a more than 40-year high this year, and the last period of such high inflation actually corresponds to the recession period of the early 80s. Fed Chairman Powell's successive aggressive tightening actions during the year were once regarded as the "Volcker 2.0" era by the industry.

Overall, the Fed actually suffered two recessions in the early 80s. Initially, January-July 1980 (six-month recession), followed by July 1981-November 1982 (16-month recession).

The U.S. recession at that time was originally due to the Iranian oil embargo reducing U.S. oil supplies, causing inflation to soar, and the Federal Reserve to fight inflation by sharply raising interest rates, also worsened the economic situation, and business spending plummeted. In the three years from 1980 to 1982, the U.S. economy had negative GDP for six quarters. The worst was in the second quarter of 1980, at -8.0%. The unemployment rate rose to 10.8 percent in the fourth quarter of 1982 and was above 10 percent for 10 consecutive months.

1990-91 (mild recession)

The U.S. recession of the '90s lasted from July 1990 to March 1991, totaling nine months. The recession was caused by the high interest rates of '89, the savings and loan crisis, and Iraq's war invasion of Kuwait. U.S. GDP growth contracted by 3.6 percent in the fourth quarter of 1990 and 1.9 percent in the first quarter of 1991. The unemployment rate peaked at 7.8 per cent in June 1992, after the recession ended.

2001 (mild recession)

Since the beginning of this century, the United States has experienced a total of three recessions, and the financial cycle and special events have become the main forces driving changes in economic operation during this period.

The recession of 2001 lasted from March to November of that year, totaling eight months. The crisis was initially caused by the bursting of the bubble in the internet industry and the subsequent depression, during which the 9/11 terrorist attacks further heightened panic in financial markets and downside risks to the U.S. economy. U.S. GDP data contracted in the first and third quarters of the year, falling by 1.3% and 1.6%, respectively. Unemployment has also continued to rise, peaking at 6.3 per cent in June 2003.

2007-2009 (deep recession)

The subprime mortgage crisis of 2007 triggered one of the worst financial collapses in U.S. history and the longest recession since the Great Depression of the 20s/30s: from December 2007 to June 2009. The financial crisis led to the collapse of Lehman Brothers and wiped out 50 percent of the planet's stock prices. By 2008, the crisis spread throughout the economy through the widespread use of derivatives.

In 2008, U.S. GDP contracted for three consecutive quarters, including an 8.5 percent decline in the fourth quarter. The unemployment rate rose to 10 per cent in October 2009. Since August 2007, the Fed has cut interest rates 10 times in a row, and the overnight lending rate has fallen from 5.25% to an unprecedented range of 0%-0.25%. On November 25, 2008, the Federal Reserve announced for the first time that it would buy agency bonds and MBS, marking the beginning of the first round of quantitative easing (QE).

2020 (Deep Recession)

The 2020 U.S. recession triggered by the coronavirus pandemic was undoubtedly the most extraordinary in history: it was both the shortest in history – less than three months (from February to April 2020) and the worst since the Great Depression. After contracting by 5.1% in the first quarter of 2020, the U.S. economy contracted by a record 31.2% in the second quarter.

The U.S. economy lost a staggering 20.5 million jobs in April 2020, and the unemployment rate soared to 14.7%, which then remained in double digits until August. In order to rescue the market, the Fed quickly sacrificed a policy combination of "zero interest rate + quantitative easing".

How do global asset classes fluctuate under the recession bell?

Historically, each stage of a recession has had a significant impact on the performance of various asset classes.

The chart below counts the performance of the S&P 500, gold, crude oil, the dollar index, the USDJPY, and GBPUSD during recessions since the 70s. Overall, the following trends are presented:

The S&P 500 performed poorly overall during the 7-stage US recession (three gains, four declines);

Gold was the best performer, with an average gain of 14%;

Oil prices rose by an average of 8.5% during these seven recessions – largely due to the surge in oil prices during the global oil crisis of the '70s and early '80s, of course, but generally subdued performance over the last five recessions due to sluggish demand due to the economic downturn.

The dollar index rose an average of 1.7% (four gains, three declines) during the US recession.

In this regard, I believe that many investors will mainly have questions about the performance of the dollar index during the US recession - why the dollar rose during the US recession. Logically, shouldn't downside risks to the US economy and Fed easing pressure lead to a weaker dollar?

There is actually something behind this that needs to be dissected in detail. In fact, based on historical performance since the 90s, the dollar index usually peaks and falls within recession territory.

This can be explained by the "dollar smile theory" of former Morgan Stanley economist Stephen Jen. According to the "dollar smile theory", in times of crisis, the dollar rises as global investors flock to safe and highly liquid assets. Then, as weak U.S. economic growth forced the Fed to cut interest rates, the dollar moved lower, hitting the bottom of the smile curve, and then rose again as the U.S. economy led the global growth rebound.

When this theory is applied in practical scenarios, it will also be affected by the relative position of the US economy in the world. Generally speaking, in the early stages of the Fed's interest rate hike, the US economy has a certain degree of resilience, while global risk appetite has declined, funds will increase the allocation to US dollar assets out of safe-haven demand. And when the US economy slows further and falls into a complete recession, dollar demand will fall back.

From the current situation, we can actually mainly compare the order in which the United States and other major economies around the world have entered recession.

According to a forecast released by Citi in September this year, although the US economy is at risk of recession in the second half of next year, other major economies in the world, especially European countries, are likely to fall into recession sooner than they do, and the monetary tightening policy shift of these central banks is also expected to be earlier in the future.

This is actually a major reason why the dollar index has been able to remain strong throughout the year, and even this strength may continue in the first half of next year. Of course, just as the dollar tends to peak and fall during recessions in history, the dollar's rally is likely to come to an abrupt end when the U.S. economy sinks deeper and deeper during recessions, when economic advantages over other economies no longer exist, and the Fed has to completely open the door to easing.

For countries that have suffered for a long time, it may take some time to endure for now...

This article is from CaiLian News