Editorial Office | Xie Changyan Wu Haishan
Editor's note
Whether the current U.S. stock market can sustain this level of trading (valuation) today may depend on whether yields in the long-term bond market will continue to rise significantly.
Whether the US economy is in recession, when the Fed will cut interest rates, and when Chinese consumption will fully recover are topics of great concern to global investors. This week, we spoke with Erik Norland, executive director and senior economist at CME Group.
He said that the recession does not come quickly after the interest rate inversion, but generally delays 10~17 months. As a result, as early as May next year and at the latest in December, the US economy will likely gradually enter a recession, and the Federal Reserve will have to cut interest rates faster than investors expect. Against this background, he is not optimistic about the subsequent trend of US stocks.
"Whether the current U.S. equity market can maintain this level of trading (valuation) today may depend on whether the yield of the long-term bond market will continue to rise significantly." Eric analyzed.
U.S. recession
It could appear as early as May next year
Editorial Board: Recently, the US economy has shown extremely strong resilience, and many voices in the market believe that the US economy may avoid recession and achieve a soft landing. This is contrary to the point you made in May, what do you think about it?
Eric Noland: U.S. interest rates have been in a downward cycle for the past 40 years, during which the Fed has had a total of 6 rate hikes or tightening cycles. Of these six tightening cycles, two achieved a "soft landing" (slowing growth but not falling into recession), but the other four eventually caused recessions. It should be pointed out that during these two "soft landings", there was no long-term and short-term yield inversion of U.S. bonds. The other four recessions caused an inverted yield curve.
Currently, U.S. interest rates are at their steepest rate inversion since the early 1980s. It is important to note that sometimes the economy will continue to grow even though the interest rate curve has begun to invert, which may make people let their guard down and underestimate the possibility of an eventual downturn.
Editorial Board: According to your research, what is the usual interval from the inversion of interest rates to the recession of the economy?
Eric Noland: From our research over the past 40 years, after the rate inversion, it will take about 1 to 2 years before the economic downturn occurs. More specifically, after the 10~17 months of the last rate hike, the economy may experience a downturn. For example, in 2006 the interest rate curve inverted in the United States, but throughout 2006 and for most of 2007, the economy continued to grow, culminating in the well-known financial crisis in 2008.
The Fed has raised interest rates by 525 basis points, the largest hike the United States has experienced since 1981. Suppose the last (July) Fed rate hike was the last, postponed 10 months back, that is, May 2024; Or push back 17 months, or December 2024 will likely be a recession.
Some investors may wonder, why does a rate hike not immediately affect the economy? The answer is that the average maturity of a general bank commercial loan or bond is two years. This means that many companies are still using loans with lower interest rates in the past.
Of course, I'm not saying that there will be a 100% economic downturn, but the signs we are seeing so far are that the risks are increasing.
At present, high interest rates and inverted yield curves are not only in the United States, but also in Latin America, Australia, New Zealand, Canada, Western Europe, etc. It's possible that sometime next year, or early in the year after, we'll see a global slowdown.
The Fed may cut interest rates more than expected
But the likelihood of interest rates going into negative territory is not high
Editorial Office: At the September interest rate meeting, the Fed still adhered to a hawkish view and raised the threshold for interest rate cuts. Market expectations for rate cuts are starting to fall.
Eric Noland: Before answering this question, let's review the deficits in U.S. history when yields have inverted. The US fiscal deficit was 2.5% of GDP in the late 1980s, a 2% surplus in the late 1990s, and a deficit of only 1% in 2007. But the current US fiscal deficit is about 8.6% of GDP, almost close to the peak of the economic expansion.
If the deficit level is not high, the government can provide relatively strong fiscal support in the event of a recession. For example, in the late 1980s, the US government bailed out the deposit and loan market; Respond to the economic downturn by cutting taxes and increasing public spending in the early 21st century; Another example is the stimulus program for banks, automobiles and other industries during the global financial crisis, while further tax cuts.
But at present, when the economy is in a downturn, it is uncertain whether the US government can support the economy by cutting taxes or increasing government public spending. The downturn may still have to be achieved through monetary policy, which could prompt the Fed to lower interest rates, even more so than investors currently expect. For example, the recession that occurred in 2001 was relatively mild, but the Fed cut interest rates directly from 6.5% to 1%; In 2008, during the global financial crisis, it fell from about 5.25% to almost zero. This has greatly exceeded investors' expectations.
Editorial Board: Do you think the United States will enter the negative interest rate range like Japan and Western Europe in the future?
Eric Noland: It doesn't look like it's going to go into negative interest rate territory right now. The Fed is currently more resistant to negative interest rates, because the experience of negative interest rates in Japan and Western Europe has led economists to generally believe that negative interest rates cannot support economic activity (growth).
I think that the Fed is more likely to cut interest rates to the range of 1%~3%. Because both during the recession of 2001 and 2008, inflation was relatively low, stable at about 2%. In comparison, inflation is now much higher, which means that the Fed may not be able to reduce it as much as it did in the past.
Of course, anything is possible, and we cannot completely rule out the possibility of entering negative interest rate territory in the future.
Editorial Board: If interest rates are cut sharply, will inflation rise again?
Eric Noland: The effect of the Fed's rate hikes on fighting inflation is very complex and will take a long time to see. From the perspective of time relationship, the relationship between interest rate hikes, the economy and inflation downward is that if the Fed raises interest rates, the economy may slow down 1~2 years after the end of the interest rate hike, but when the economy declines, the decline in inflation will still lag. It is possible that after the economic slowdown, it will be another year or two before inflation pulls back.
Whether the current level of inflation in the United States is too high depends on which angle you look at it. Headline inflation recently rose by 3.7%, mainly due to higher oil prices; Core inflation recently fell faster at 4.3%.
But now many economists are seriously discussing a new concept called super-core inflation. "Super-core inflation," excluding about 24 percent of the CPI, represents a special measure of rent, known as "owner's equivalent rent." It assumes that the homeowner pays himself rent. For example, renters' rents rise by 10%, and when calculating the CPI as an economic statistic, the landlord will also pay 10% more rent. The problem is that there are no landlords who actually pay rent for themselves. Therefore, if the landlord's equivalent rent is excluded, the CPI actually only increases by about 2%. Looking at this indicator, it can be said that the Fed has successfully controlled inflation.
Editorial Board: China is currently in the process of consumption recovery, but there is no high inflation in the European and American markets, what do you think are the factors behind this difference?
Eric Noland: I think it's mainly due to the different ways in which different countries have handled the epidemic. For example, in the past few years, in response to the epidemic, the United States has spent 30% of its GDP, equivalent to $6 trillion, on economic boost during the pandemic. Although the scale of European distributions is not as large as that of the United States, it is also very considerable and more targeted. The reason for this is that the savings rate of Americans before the epidemic is very low, only about 3%, and the average is between 7%~10% in different countries in Western Europe. Against the backdrop of such low savings rates, it will be difficult for households in the United States and Europe to survive the pandemic without substantial government support. With the substantial support of the government, the demand for goods purchased by residents will rise, but the supply of goods will not rise. The most basic economic law of supply and demand tells us that if demand rises and supply does not change, prices will rise.
In China, where the average household can save up to 30% of their income, households that spent some of their savings during the pandemic are now accumulating savings again. In addition, China's current consumption accounts for about 35%~40% of GDP, while Europe and the United States can account for 60%~70%. The combination of the above factors makes China's inflation rate relatively low, and the recovery of consumption is still in progress.
The premise that U.S. stocks continue to maintain high valuations
Long-term bond market yields are no longer higher
Editorial Board: If the U.S. economy has a recession, which industries or sectors will be more affected?
Eric Noland: In the last 40 years, each recession that we have seen in the U.S. economy has been very different. In 2006 and 2007, residential real estate had a high vacancy rate, and the sharp decline in real estate prices dampened consumer confidence and led to the contraction of the balance sheets of many banks. For example, in the 2001 recession, consumer spending and residential real estate remained relatively strong. The recession saw a sharp contraction in business investment and a sell-off in technology stocks.
At present, the vacancy rate of residential real estate in the United States is actually very low, so if the recession caused by austerity policies, the most affected this round is likely to be not residential real estate, but commercial real estate and other industries, such as office buildings, shopping malls or shopping malls.
Editorial Office: Recently, U.S. stocks have performed poorly in the environment of raising the threshold for interest rate cuts, how do you think about the performance of U.S. stocks?
Eric Noland: I think there's a lot of risk in the stock market right now. First, the stock market valuation is relatively high now; At the same time, the high valuation of the stock market is based on the benchmark expectation of low long-term interest rates. But the most striking change in the interest rate market now is that it has risen sharply from the downward trend of more than 40 years. This will have an important impact on the investment market in all fields.
We looked at the relationship between the market capitalization of the U.S. stock market and the size of the Fed's balance sheet. The conclusion is that the expansion of the Fed's balance sheet over the past few years has boosted stock market valuations. During the pandemic, the Fed implemented quantitative easing, and its balance sheet expanded significantly. In the early days of the epidemic alone, the Fed printed $3 trillion in three months, and continued to print money for nearly two years, about $120 billion a month. U.S. stock market valuations also rose sharply during this period.
But the problem for the stock market now is that the Fed is going to start shrinking its balance sheet at $95 billion a month.
At the same time, higher long-term bond yields are not good news for investors in the stock market. In general, stock market valuations are negatively correlated with long-term bond yields.
In the 1950s, 1960s, and after 2000, the valuation of the stock market was very high, and one of the reasons was that the yield on the bond market was very low; In contrast, in the 1970s and 1980s, bond market yields were relatively high, and the valuation of the stock market was even less than 1/4 of today. So whether the current U.S. stock market can maintain this level of trading (valuation) today may depend on whether the yield of the long-term bond market will continue to rise significantly.
Editorial Office: You are not optimistic about the future direction of the stock market. But according to the logic you explained earlier, as the Fed cuts interest rates, long-term bond yields may also fall in the future, and from this point of view, it seems positive for the stock market?
Eric Noland: That's a good question, but it's also hard to answer. In the event of a recession, the Fed may lower short-term interest rates, but the impact on long-term interest rates, such as 10-year and 30-year yields, is vague. It is possible that it will also fall, but it may not be as much.
In addition, from the perspective of the stock market, if it enters a recession, the company's profits will fall sharply. The past two recessions have seen significant declines in the valuations of S&P 500 companies. For example, during 2000~2002, the valuation of S&P 500 companies fell by 50%; During the period from October 2007 ~ February 2009, it fell by 60%.
(This article was published in the September 29 issue of Securities Market Weekly, and the views of the guests are personal and do not represent the position of this journal.) The stocks mentioned in this article are only examples and do not recommend trading. ）