It has not been a Happy New Year for financial markets. Fear is the predominant emotion, coupled with a sprinkling of self-righteousness as perennial bears find their voice once more. As always we need to be careful to separate fact from fiction (or forecast, if you prefer).
If we’re sticking to the facts, this sell-off is way over-done. To make us worry that we are about to plunge into global recession we would have to hear more convincing explanations as to how the factors impacting asset prices are going to become net negatives for global growth. So what’s all the fuss about?
China slowing, but global contagion unlikely
The apparent trigger for such a lousy start to the year has been bad news from China. Well, not so much bad news in a fundamental sense as bad news in terms of equity prices. Given the size of its economy, it is understandable that people worry about the consequences for the rest of the world of China getting wobbly. Understandable, but almost certainly wrong.
The effect of China as producer to the world are far more profound than those of China as consumer of the world’s goods. It is notable that amid all the bearish prognostications, there is no coherent case made as to how slower Chinese growth impacts anything other than prices (i.e. forcing them lower) for most of the rest of the world. But who needs coherence when there are flames of panic to be fanned and publicity to be found in screams of “sell-everything!”
Cheaper oil is a global positive
If China’s equity market is the villain of the piece, then riding shotgun is the oil price. The collapse in oil prices over the past twelve months has been extreme. At first glance, the casual reader might observe that this is great news – unless, of course, you’re an oil producer or employee (i.e. hardly anyone). As we’ve said before, cheaper energy is undoubtedly positive for global growth. This fact is currently being overwhelmed by the fear that ‘it’s telling us something’ about demand. It might be. And if you avoid looking at all the evidence to the contrary it’s probably quite worrying. (see more on this here).
Is this the next 2008?
In short, no. In our view, part of the reason investors are so inclined towards pessimism today is that the trauma of 2008 still lingers in the memory.
Bears argue that the experience of 2008, when a crash in housing drove correlated declines across sectors and assets, could be repeated in 2016 with a crash in. In our view, this misunderstands the specific, and very distinct, role of each of those sectors. A decline in the housing sector is not good news for any part of the economy, a decline in the energy sector is a stimulus for many.
The second important point about 2008 is that it is a sample of one. When 2008 happened, we had never had a 2008 before. The very fact that we experienced the trauma of 2008 renders it much more likely to appear in our minds as a plausible outcome now but, ironically, possibly makes it less likely to happen again – mostly on account of the subsequent reforms which have significantly reduced risk and improved balance sheets in both the financial and household sector.
Forecasts of recession are unfounded
This notion that the market is a harbinger of doom is also being utilised to draw a straight line from declining equity prices to forecasts of recession for the global economy. Some ‘professional forecasters’ (yes, it is paid work) have felt inclined to publicise their carefully calibrated recession probabilities as now being greater than 50%. Up to now such spurious accuracy is only available for the future of the US economy, but if the next three weeks are like the last three, more doom-laden forecasts will surely follow.
The analysis behind such forecasts is often superficially compelling but ultimately incomplete and often inconsistent. Cobbling together a convincing-sounding yarn from a list of gloomy, but disparate, factors does not constitute a helpful insight. In the past, there have been precious few reliable indicators of recession before a recession has actually already begun. There are three techniques that have been more reliable than most – and they are, thankfully, very simple.
The first is the yield curve, specifically the gap between 10-year yields and 3-month interest rates (as explained here). This measure puts the probability of a recession taking place within the next 18 months at less than 3%. Another Federal Reserve measure, this time a model from the St. Louis Fed’s FRED database (using an amalgam of current macro and financial data puts the probability at less than 1% that the economy is already in a recession. Finally, the TED spread (the gap between short-term Treasuries and the market 3-month EuroDollar rate) is giving no indication of increased recession concern in short-term lending behaviour.
We should be careful not to endow such measures with too much power, especially with the interest rate environment in general looking very different today. However, it is the fact that others are ignoring it that is interesting. When commentary is ignoring good data and over-emphasising the negative, it should serve to embolden those who see opportunity in recent price falls.
So why the worry?
Well, there’s plenty of bad news around the energy sector which has been big enough to hit the aggregated macro data. What is clear, however, is that this weakness has not, up to now, been contagious (as shown in figure one). Indeed, given the beneficial impact of lower input costs and higher real spending power, it should be no surprise that non-energy industry is actually doing fine and that consumer spending is growing.
It’s not just about the US either. Looking to Europe, both the UK and Euro Area data continue to show more expansionary signs, outweighing the gloom emanating from some exporters.
More reason for optimism than pessimism
Observing the disparate fundamental performance of energy-exposed sectors and just about everything else, both within and across economies, it seems more plausible that while specific areas of economies are suffering a sharp recession already, there are many more experiencing conditions ranging from modest demand growth to robust expansion.
A widespread recession tends to occur when sectors of the economy are affected by a common factor, such as tightening financial conditions. Could the financial sector provide this correlating factor? Of course it could, but we need to ask ourselves whether the market is complacent about this risk, or, given the experience of 2008 and recent market price moves, we are overly focused on the likelihood of a repeat event.
It is all too easy to get swept away with pessimism when market price action is seemingly acting in such a compelling fashion – going against the apparent consensus is emotionally very difficult. But as Charlie Munger once said, “anyone who finds it easy is stupid.”