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Hard Not Soft

From our perch, the odds of a hard landing remain uncomfortably high. While risk assets have stabilised following the regional bank and Credit Suisse episode in March, we continue to see weakness in a range of market and macro signals underneath the surface. As we noted recently, some equity investors appear to want all the benefits of rate cuts without enduring the pain that would warrant them. Furthermore, monetary policy famously works with a long and variable lag. The magnitude and speed of the tightening cycle last year is only starting to impact the real economy and asset markets. Notably, the tightening in credit and lending standards commenced before the regional banking crisis. That episode likely accelerated the tightening in credit that was already underway.

The good news is that Treasury yields have declined following the moderation in headline inflation pressure. That has been supportive for rate sensitive (long duration) growth companies and has contributed to a modest re-rating of the warranted valuation multiple. However, markets are priced for material rate cuts almost immediately after the peak, despite Fed communication insisting that the policy rate will have to stay flat or higher-for-longer.

As we noted recently, the conditions that would warrant 150 basis points of rate cuts are probably not good for growth and profits. In the last two major rate cutting cycles, a lower fed funds (discount) rate did not support technology stocks apart from a temporary bear market rally or suspension of disbelief. So far year to date, the S&P500 market-cap weighted index has outperformed the equal-weighted index by more than 5%. Put another way, market breadth supporting the rally has been extremely poor (chart 1).

The material underperformance of small companies relative to the S&P500 also suggests weakness in underlying cyclical conditions. While the Russell 2000 index is dominated by regional banks, the weakness in small cap is consistent with the tightening in lending standards, credit, and domestic growth momentum (chart 2).

It is also notable that credit spreads in the leveraged loan market (dominated by commercial real estate) have continued to widen since the regional bank episode. Moreover, the CMBS market and regional bank prices remain extremely depressed. This suggests that US labour market conditions are likely to ease over the coming months, which is already evident in temporary hiring and the small business survey and job openings (chart 3).

The final point to note is that the New York Fed’s recession model indicates that probability of a recession is around 60%. The model incorporates the yield curve which is at levels that has always led to a recession (chart 4). Note that the probability is higher than it was heading into the 2008 episode. Moreover, it is consistent with the tightening in lending standards, ISM surveys, small business, homebuilder, and consumer confidence. Our sense is that lending conditions will only tighten further from here. Small US banks face tougher regulation, falling net interest margins and greater matching of assets and liabilities in the future. The decline in bank lending has already been at a recessionary pace.

In this context, the US equity risk premium is extremely modest. Indeed, the spread is closer to peak (bull market) levels rather than distress. Similarly, credit risk spread compensation and implied volatility on a cross asset basis is extremely low apart from fixed income. Credit spreads in both investment grade and high yield corporate bond markets are below average. In recession spreads typically widen to distressed levels (around 1000 basis points in high yield).

While the improvement in headline inflation is positive, core inflation (services ex shelter) is only modestly below peak and a constraint on the Fed and belief in lower rates. As we have noted recently, too many investors are analysing this episode as a credit cycle like 2008. However, the current crisis is not a credit event. It is an asset cycle. The system became over-leveraged to asset bubbles, especially in private assets such as venture capital, private equity, and debt. We are most concerned about the mark-to-market risk in private equity, venture capital and commercial real estate (final chart). The positive news for Asia Pacific is that valuation and sentiment are closer to bear market trough conditions.

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