Remaining precariously erect, like a tower of Jenga blocks down to its structural skeleton, the global economy can only afford so many more building blocks to be stripped away before a weakness begins to show. Last week, the US Institute of Supply Managers manufacturing data release showed the reading drop to its lowest level since June 2009, making it the second consecutive contractionary result of the measure. The story was similar in Germany as well, with Markit’s Purchasing Managers Index falling to lowest-since-2009 levels, deepening what can now be called a certain contraction in the EU’s largest, most industrial economy. In the UK, manufacturing was seen to remain contractionary too, though propped up to respectable levels by what some believe is a push to stockpiling and inventory building ahead of an uncertain Brexit. With all of these major economies foreshadowing an intrinsic weakness, what can be considered just a ‘bad month’ or a ‘bad quarter’? Indeed, only hindsight is clearest about which signals show the global economy in a true recession.
Amid last week’s bout of manufacturing misfires, there was a somewhat predictable parallel shift in implied interest rate expectations. The prospect for the European Central Bank remained on steady course, given the amount of recent monetary policy action accommodating the conditions. However, the Bank of England’s policy rate change probability shifted to a 25% chance of a cut in November, from 10% earlier in the week, and the Fed’s end of October meeting saw the chance of a cut increase to nearly 100% (!) from an approximately 60% chance at the start of the week.
Chart 1: The S&P 500 makes a clear upward trend towards recent Fed rate decision dates, which were coupled with near certain expectations of a cut
Previously, these types of dramatic swings in rate expectations have led to a surge upwards in the equity markets (chart 1), particularly in the S&P 500 and Dow Jones. Seemingly unintuitive, given the fact that rate cuts fundamentally mean supporting an economy that is struggling in some way, cuts as of late have come to mean ‘extra support’ and ‘cheap debt’, almost an insurance against failure in the near term. Though, the increased certainty of a 3rd impending rate cut from the Fed caused both the S&P and the Dow to fall more than 4.5% peak-to-trough during last week. Could this be a sign of sentiment shift?
Quick and the Dead: Yield Curve vs Job Claims
This wouldn’t be the first sign of turmoil in the equity markets over the last two years, though. The ‘return to volatility’ spell in February 2018, or the ‘is this the recession?’ doom of December 2018 that dropped equities nearly 16% were certainly a scare (chart 2). May 2019 brought a sour 7% loss on the S&P, whilst August saw a milder 6% drop. Each downward bout has seemingly had its subsequent rally to abate losses, albeit less and less successfully each time. To date, we have not recovered past the end of July highs, and may have already started on the next bottomwards track.
Chart 2: The VIX index saw a large ‘pop’ in volatility in February and December 2018 (green), with lesser surges seen in May and August 2019 (yellow)
The saving grace in last week’s episode for the US was a moderating chunk of employment data that seemed to cover up some of the weakness displayed in the manufacturing results. The unemployment rate of 3.50% hit a 50-year low, although this is typically regarded as a lagging indicator of performance or recession. Payroll and earnings came in with an insignificant miss, while continuing & initial jobless claims were inline with expectations. These employment figures can become something of a clairvoyant when interpreting periods of market downturn. The classical use of the yield curve to forecast a recession and interpret a downturn may not provide the type of notice required to prepare for such a risk. A market adage once said, “those quick to the trigger know to watch claims, whilst the dead watch the yield curve”. We have seen yields moving lower since Q2 2019 and a dip in the middle part of the curve, though the 2s10s spread (yield spread of US Treasury 2 and 10-year notes) remains positive for now. Keeping an eye on employment data first will be paramount.
Vols Still at an All Time Low
One particularly perplexing piece of the puzzle outstanding is the continuing all time low levels of implied volatility in major currency options (chart 3). This ‘catch all’ measure acts a proxy for the effect of all available market information on option values, outside of time to expiry, spot level, strike and interest rates. Traditionally, this measure has been a reliable indicator of sentiment in the currency markets, particularly when large intraday moves (ie. surprises) become more frequent. In recessionary environments, typical flight to safety responses see a large increase in the demand for USD in order to purchase ‘risk-free’ US Treasury bills and other safe assets.
Chart 3: EURUSD 1-month at-the-money option volatility has drifted downwards since 2015, within 16bps of the all time low in April 2019
While the US Dollar Index has reached 2-year highs this month, sharp movements of USD strength have not been witnessed. This could bring into question the sense of safety the USD has been presumed to retain, especially with ever increasing geopolitical risk and the uncertainty associated with the current US presidential administration. Talk of dollar intervention and a possible loss of central bank independence could be reason enough to lose trust in the integrity of the USD as the world’s currency, accented by the massive, USD 16 trillion market for negatively yielding securities. In other words, investors are willing to pay to place their money with a local institution in the EU or Japan, rather than move it to the US to earn positive returns.
With unprecedented monetary policy accommodation, quantitative easing and heavy regulation around the world, the global economy has warded off the after effects of the 2008 crisis and continues to artificially prop up, for the most part, a ballooning capital market. Almost all experts and amateurs alike would agree that synonymous with Sir Isaac Newton’s Law of Gravity, a recession is inevitable eventually. Trying to identify the precise moment that the global economy has tipped over into a full scale correction or retreat is futile, particularly among the political confusions of EU populism, the UK divorce settlement and Ukraine-gate. Keeping an ear to the ground on employment data and option volatilities may be of some assistance, again with so many influential factors at play. There remains upside potential in the path forward, surely. But what one day will appear to be another poor week on the surface, at some point will not be a false alarm.