Rate Reversal Will Be Swift When Sentiment Cracks

Authored by Simon White, Bloomberg macro strategist,

A break in market sentiment has the capacity to trigger a recession in a US economy becoming more fragile due to the energy shock. Rate cuts would then rapidly be priced back into the front end.

The imminent chance of a US recession remains low, but the frothing of underlying currents and the potential for military re-escalation in the Middle East requires enhanced vigilance. Downturns, when they do arrive, are mercilessly abrupt and unforgiving to unhedged portfolios.

Sentiment, as reflected in surveys and market prices, has held up remarkably well since the war. Advanced S&P Global PMIs covering the first few weeks of March have remained supported, with the composite measure slipping only marginally to 51.4, while the S&P 500 is down a mere 4% from the Iran war’s onset.

As we will see, this unflappability needs to continue if the US is to avoid a recession and an ensuing deep decline in markets.

Most assets are far from pricing this eventuality, even though market-implied odds of a recession have been creeping higher since the war began. US and global stocks are consistent with about a 20% chance of a contraction, based on their moves before prior downturns, while for credit spreads it’s lower.

Copper and the yield curve are more pessimistic, with implied odds of 45-55%. Either way, every market faces a significant repricing in the event of a recession.

The low implied probabilities are probably fair, for now at least. My Recession Gauge consists of 14 submodels based on a wide array of economic and market indicators, at least 40% of which need to trigger for the gauge to signal an imminent recession (within 2-3 months). Only about 20% are activated at the moment (including a just-triggered oil-surge indicator), implying near-term recession risk is low.

However, when the gauge starts to rise above 20-30% it tends to do so rapidly (see chart above), reflecting the real-world regime-shift nature of recessions. It won’t take much if sentiment deteriorates.

Recessions are formed when “hard” economic data, eg employment and manufacturing data, become stressed at the same time as “soft,” market- and survey-based data. Weakening hard data will eventually sink the soft sentiment-led data too as markets fall in response to weaker prints, and surveys sour as sentiment also falters.

Today, hard-data stress has risen (see brown line in chart below), as housing data, automobile sales and coincident data overall have weakened this year.

It will go irretrievably wrong if a negative feedback loop forms between the hard and soft data, with weakening sentiment impeding real economic activity, leading to yet more stressed hard data. A cascade then begins that typically culminates very rapidly in a recession.

It thus all now hinges on sentiment. Fortunately the soft data has not — yet — shown any significant weakness (ISM, margin accounts, money growth, yield curve, etc). But if it soon starts to rise, taking both it and the hard data above the red-dashed line in the chart, then a recession within the next 2-3 months becomes highly likely. The war provides plenty of fodder for both types of data to degrade.

Further, today’s situation, with the hard data becoming stressed first, is the worst of both worlds. When the soft data leads, the Federal Reserve has the chance to nip the feedback loop in the bud by easing policy and jumpstarting sentiment before the hard data has a chance to hit the skids.

However, there is less the Fed can do put hard-data stress back in the bottle – the damage has often already been done. That’s why the prime facie low recession risk today should not offer false comfort.

The problem lies with oil. That might seem counter-intuitive for the US: it no longer has to depend on imported oil and gas, and it is now a much less intensive user of energy. As the chart below shows, one barrel of oil supports over three times as much real GDP as it did in the 1970s.

But as Gerard Minack of Minack Advisors points out, there lies the problem: the loss of a barrel of oil – as high prices lead to demand destruction – can have three times the negative impact on GDP, assuming symmetry. The gift to GDP that oil gave on the way up can be withdrawn as swiftly on the way down.

Adjusting my Recession Gauge, by weighting the oil submodel to reflect the increasing importance of crude on GDP, takes the reading from just over 20% to 30%, shifting it uncomfortably close to the 40% threshold that signals an imminent recession. It would take the activation of only two more submodels to get us there.

In an unwelcome parallel to the 1990 recession, the energy shock is hitting at a time when there are signs of credit deterioration from widening spreads and stress in private credit.

Credit was already tightening from the savings and loans crisis in the late 1980s when Iraq invaded Kuwait in August 1990, causing oil prices to double. The recession had begun in July, but the energy shock prolonged and deepened the downturn, which lasted until February of the next year, taking stocks 20% lower.

What would a recession mean for markets today?

As mentioned, no assets are currently priced for one. Stocks would sell off further, with the median drop in downturns since 1960 at 12%. But that masks more malign episodes, such as that which followed the OPEC I oil shock in 1973/74, of 45%.

Bonds will rally, but this being a stagflationary shock, they may rally much less than they have done in recessions over the last three decades.

And as discussed the other week, in commodity-induced contractions commodities do quite well.

Where we might see one of the biggest repricings is the US short end. The market was quick to remove about 60 basis points of cuts expected for this year since the war, but a whiff of a recession is likely to have the Fed quickly back in its safe space, upholding its unemployment mandate, and avoiding affronting the president.

It’s not a trade for now, yet if and when sentiment starts to fracture and recession risks heighten, the move to price back in rate cuts, even deeper than before, will be unmercifully swift.