The soft landing is a myth

The digital financial platform The Market NZZ provides experienced investors with orientation, analysis and recommendations on what is happening on the global financial markets. In the “The Big Picture» Editor-in-Chief Mark Dittli takes a look at the general weather situation on the markets every week.

“Even stupidity is better than totalitarianism.”
George Orwell, British writer and journalist (1903–1950)

A thirty-year phase of globalization and opening has come to an end. A new era has begun, characterized by gradual deglobalization and a fragmentation of the world economy. This development is being driven by a major new ideological conflict between liberal democracy and authoritarianism.

“It’s ignorant when people in the business world think we can carry on as we have been,” said George Magnus, the former chief economist at UBS. in this interview.

The second Cold War – Cold War II – with the protagonists USA and China will keep us busy for many years to come. The historian Niall Ferguson has in his last Bloomberg column Here are some thought-provoking parallels:

“The Second Cold War is like a strange reflection of the First Cold War. In the First Cold War, Russia was the senior partner, the junior was China – now the roles have been reversed. In the First Cold War, the first hot conflict was in Asia (Korea) – now it is in Europe (Ukraine). In the First Cold War, Korea was only the first of many confrontations (…), today the crisis in Ukraine is likely to be followed by crises in the Middle East (Iran) and the Far East (Taiwan).»

Well, we don’t want to speculate about the next twists in geopolitics in the “Big Picture”, but rather take a look at the financial markets. Because history is also happening there.

This week the time has come: The most important segment of the yield curve in the US is inverted. The 10-year Treasury note yield was 2.39% on Friday, almost six basis points below the 2-year Treasury yield:

We have at this point pointed out several times in recent weeks about the abnormally rapid flattening of the yield curve and the associated warning of an economic slowdown.

In the past, an inversion of the yield curve has proven to be an accurate signal for an impending recession (see gray areas in the chart):

But every time the yield curve inverts, a heated debate erupts in financial markets as to why the recession signal might turn out to be wrong this time.

It’s no different today. At the moment, for example, it is often said that the bond markets are being manipulated by the policies of the central banks and that the signals on the yield curve are therefore impure. In addition, it is often pointed out that the curve between three-month and ten-year Treasuries is still far from an inversion.

Well, we don’t want to bore you with a discussion of yield curves. Of course, there is no law that says that an inversion must be followed by a recession. And – this is important in the current environment – ​​a minimal inversion during a trading day is by no means a strong signal.

Still, it would be foolish not to take the flat yield curve seriously. Because the bond market reflects the expectations of market participants, and these can be located as follows:

In that light, it’s not surprising that the 3-month/10-year yield curve hasn’t inverted yet given that the Fed only started raising interest rates two weeks ago.

Two-year yields, on the other hand, have skyrocketed in recent weeks as markets realize the abnormally rapid rate at which the Fed will hike interest rates in the coming months to fight stubborn inflation.

This is the development that is relevant from our point of view: The bond market has realized that Fed Chair Jerome Powell is serious about his announcements. He will subordinate everything to combating inflation, including the state of the economy. The Fed is consciously taking the risk of provoking a recession with its tightening of monetary policy.

The last Fed chairman to face this dilemma – inflation or recession – was Paul Volcker over 40 years ago. And he chose the path of recession.

We are therefore extremely skeptical these days when we read arguments why the situation is different this time and why the signals from the inverted yield curve should suddenly be irrelevant. As value investor Sir John Templeton once said, the four most dangerous words in an investor’s life are “This time is different.”

Does that mean a recession is imminent and stock markets are in danger of falling?

No.

As the analysts at the Canadian research boutique BCA calculate, in previous interest rate hike cycles – BCA has examined the more than 50 years since 1969 – an average of 15.9 months elapsed between an inversion of the yield curve and the official start of a recession in the USA. The stock market, as measured by the S&P 500, continued to rise for an average of ten months from the time of the inversion until it peaked a good five months before the start of the recession.

Unfortunately, these historical patterns are of limited use in the current situation. Every cycle is different, and the current one is anything but “normal”: the economy suffered a massive slump in 2020 under the impact of a pandemic of the century and recovered explosively in 2021, driven by unprecedentedly expansionary monetary and fiscal policies.

This recovery met a severely disrupted supply-demand relationship, which has pushed US inflation to its highest level in 40 years. And to combat this inflation, the Federal Reserve must now apply the monetary brakes much harder and hike interest rates much faster than in previous interest rate hike cycles.

What we’re trying to say is that this cycle is much more severe and happening much faster than the last four rate hike cycles (2015-2019, 2004-2006, 1999-2000, 1994-1995).

Every rate-hike cycle begins with the widespread hope of a soft landing: that the Fed manages to tighten monetary policy just enough to cool demand slightly and ease inflationary pressures without sending the economy into recession.

Forget that. The soft landing is unfortunately a very rare outcome of monetary policy. In the period since 1965, there have been eleven interest rate hike cycles in the US. Eight of them ended in a recession, only in three cases – 1965, 1983, 1994 – did the economy escape without a slump. And in none of those three years has the Fed had to fight stubborn inflation, so it was a comparatively benign environment for monetary policy.

We share the opinion of market observer Alfonso Peccatiello, he in this interview explains: «I am still of the opinion that the motto Don’t Fight the Fed applies in both directions – both with loosening and with tightening.”

We consider the hope of a soft landing to be an illusion. The danger is very high that the Fed’s monetary policy braking maneuver will lead to a recession.

But why is the combination of rising interest rates and a recession actually so detrimental to share prices?

To answer that question, we just need to take a quick look at what actually drives a company’s stock performance (and, at the aggregate level, the stock market as a whole). Put simply, there are only two:

That’s it. Not more. For the total return on a stock investment, the annual dividend payout is added, but we’ll leave that out for the purposes of our discussion, since the dividend is a function of company earnings.

So let’s say Company X manages to grow its earnings per share like clockwork by 8% year over year. And further assume that its valuation is sticky and its price-to-earnings (P/E) ratio is, say, flat at 15 year over year.

In this case, Company X’s share price would have to increase by 8% every year.

Of course, the assessment is not rigid. It varies significantly with market participants’ expectations of Company X’s long-term growth prospects and the interest rate used to discount expected future profits into the present.

Now suppose that Company X’s earnings growth continues at 8% per year, but its valuation increases by 10% per year because investors are becoming more optimistic about its long-term prospects and/or the discount rate continues to fall. So Company X’s P/E ratio would be 15 in the first year, 16.5 the next year, 18.15 in the third year, etc.

This year, the company’s share price would rise 18% year over year — 8% thanks to earnings growth and 10% thanks to valuation expansion.

Here is a rudimentary summary of the concept using a concrete example from the construction chemicals manufacturer Sika:

The result of these two drivers was this price development:

So far so good. This is the most beautiful of all combinations: profit and rating increase.

However, these two influencing factors – profit and valuation – do not always move in the same direction. For example, profit may increase and valuation may decrease. In this case one speaks of a valuation contraction. Or (rarely though), profit can go down and valuation can still go up.

However, the worst combination of the two drivers is when earnings per share fall and when at the same time valuations are shrinking – and that is exactly what happens in an environment of recession and rising interest rates.

The next six to twelve months will therefore be extremely exciting on the markets. Either it will become clear that Fed Chair Powell is actually having a “Volcker moment” and is provoking a hard landing and recession. Or he will give in at some point and break off the experiment of tightening monetary policy. In the first case, a slump in the stock market is inevitable. In the second case, the bull market can continue.

The switch – Scenario A or Scenario B – will be decided in the Fed boardrooms.