Since the last time I was writing this commentary markets have relaxed about the possibility of a global downturn. Financial conditions have eased in developed markets, and business sentiment has recovered shortly after. Economic activity itself has improved-although not enough, in my opinion, to justify to market rebound. Real-time indicators picked up during March in the U.S., China, emerging markets and, to a lesser extent, the eurozone.
Four of the latest five U.S. downturns have been followed by a global recession
In contrast, the economy seems to be getting weaker in the U.K. and Japan. Financial markets have lived in a heightened state of alert for the last two years. Economic growth has remained below its long-term trend of around 3.5% since 2014. So when, on at least three occasions, activity growth has dipped for a few weeks, fear of a global recession has spiked.
A Brighter Outlook Following February Fears
In February we lived one of those episodes. The dread is ever more justified because the U.S. exhibits some of the tell-tale signs of a business cycle in old age: falling profits and low unemployment. Although global and U.S. cyclical peaks don’t always coincide, four of the latest five U.S. downturns have been followed by a global recession; 1975, 1982, 1991, and 2009.
A global recession is characterised by the International Monetary Fund (IMF) as a contraction of world output per capita, accompanied by a pervasive and persistent deterioration of other indicators of activity, such as capital flows, trade, oil consumption, and unemployment. Markets had a boomerang first quarter. Quick retrenchment in January and early February gave way to a surge of optimism, which by the end of the trimester left investors more or less where they had started.
Major drivers appeared to be oil prices, the renminbi, and central bank announcements. That risk premia would swing so dramatically in such a short period of time underscores three features of today’s market functioning. First, the U.S. Federal Reserve faces a late-cycle dilemma: a tight labour market calls for interest rate hikes, but low inflation and below-trend growth don't support them. Second, the co-dependence of financial markets and monetary policy, not just in the U.S., has reached pathological levels.
Third, the world economy is more and more a two-headed animal: news from China can overshadow news from the U.S. The S&P500, which at one point had lost 11%, recoiled and ended Q1 with a slight gain of 1.3%. The turnaround came shortly after Fed chair Janet Yellen told Congress on February 10 that market volatility posed a threat to U.S. growth. The warning was echoed by the Federal Open Market Committee’s (FOMC) March statement, and again by a speech by Yellen in late March. The Fed’s new dovish tone was a volte-face to its stance in December, when it had raised policy rates for the first time in over ten years.
UK: Flat Returns Thanks to Brexit
British equities followed a similar path, with the FTSE 100 eking out 0.1% for the trimester. Among the positive factors were higher commodity prices and a weaker pound, plus the consummation of the merger between Royal Dutch Shell and BG Group. The main beneficiaries were the basic materials sector, oil, and gas. On the other hand, the long shadow of Brexit kept investors away from financials.
Eurozone equities were also sharply down for the first six weeks of Q1. The subsequent reversal from mid-February of 2.8%, however, couldn’t make up for the losses and the MSCI EMU index wound up losing 6.6% in the quarter. The Brussels terrorist attacks piled on top of global economic concerns to keep indexes down. Financials performed particularly poorly, as market participants worried about the impact of negative deposit rates on bank profits.
Deutsche Bank and Italian banks faced specific challenges. Government bonds of the main reserve currencies had positive returns. Negative interest rates, first adopted by the central banks of Denmark and Switzerland and Sweden, spread to Japan and the eurozone, and set off rumours that the Fed and the Bank of England might eventually jump in the bandwagon. The immediate fallout has been the propagation of negative yields over a broader swath of the sovereign debt market.
Developed World Debt Bears Negative Yield
According to calculations by the Financial Times, about a third of developed world debt bears now a negative yield, up from 16% at the end of 2015. Market volatility in stocks and commodities also contributed to a flight to safety, from which prime sovereign bonds where the main beneficiaries. The U.S. ten-year yield dropped to 1.8%, from 2.3% in late December.
Gilt and bund yields for the same maturity also retreated by about 50 basis points, ending the quarter at 1.4% and 0.15%. In the credit market U.S. high-yield bonds had an exciting quarter. The market worried that low oil prices would bankrupt highly leveraged energy companies, and so risk premia – the gains that makes the risk seem worthwhile – soared to unheard-of levels. Other industries suffered contagion. In the second half of the quarter both energy and non-energy high-yield spreads snapped back to December levels. Investment-grade credit marginally outperformed government debt for dollar- and euro-denominated bonds, but not for sterling credit.
