Views From the Floor

Anatomy of a Recession

How does a typical US recession unfold? We think the sequence looks something like this:

1. First, there is a sustained uptick in inflation as corporate input prices rise;
2. This leads to a sustained decline in profitability, as firms are unable to pass on price increases to consumers with the same speed at which they are receiving them from raw input suppliers;
3. This causes the Fed to start fretting and to try to head off rising inflation with rate hikes;
4. With monetary policy pushing up the short end of the curve whilst the long end is anchored by fears around long term economic growth, we see an inversion of the yield curve;
5. This means that banks, whose business model is generally to borrow short and lend long, become unprofitable and stop lending. This is particularly bad for the high yield space where companies are highly levered and tend to roll their debt over short periods: with funding markets drying up they are forced to pay more and more for their finance, and HY spreads consequently blow out;
6. But this can’t go on for very long, and as liquidity dries up these companies start going bust and laying off workers. Initial jobless claims spike and recession descends.

This is borne out in the data. Below we show each of these metrics for every NBER recession going back to 1922 (shaded blue), with the preceding 12 months before each in white. The results are summarised in the table. Of course our framework doesn’t work like clockwork every time because real life is messier than that. But there is clear pattern. And what is equally clear is that today is not conforming to recession warning type. We’re aware that the 10-2 has briefly inverted (although not over a month end so we do not include in our table) but every other measure doesn’t look like a typical inflationary recession (see the final white segment of the charts).

The twist is that where we are now may be a-typical. Negative rates have never been seen before, which could presage a deflationary end-of-cycle. The anatomy of a conventional inflationary recession is clear. But we may be looking at a different animal.

Figure 1. Recession Predictive Data

Source: Man Group; as of 15 August 2019.

Figure 2. CPI During Recessions and Preceding 12 Months (1922-2019)

Source: Man Group, Bloomberg; as of 15 August 2019.

Figure 3. Corporate Profits/Gross Value Added, During Recessions and Preceding 12 Months (1922-2019)

Source: Man Group, Bloomberg; 15 August 2019. Insufficient data available for the period 1922-1930.

Figure 4. Fed Funds Rate, During Recessions and Preceding 12 Months (1922-2019)

Source: Man Group, Bloomberg; as of 15 August 2019.

Figure 5. 10-2 Yield Curve, During Recessions and Preceding 12 Months (1922-2019)

Source: Man Group, Bloomberg; as of 15 August 2019.

Figure 6. High Yield Spreads, During Recessions and Preceding 12 Months (1922-2019)

Source: Man Group, Bloomberg; as of 15 August 2019.

Figure 7. US Weekly Jobless Claims (3-Month Moving Average), During Recessions and Preceding 12 Months (1922-2019)

Source: Man Group, Bloomberg; as of 15 August 2019. Insufficient data available for the period 1922-1967.

Volatility Spills Over

While investors are accustomed to idiosyncratic risks in single name equities, recent geopolitical events that have caused dislocations in local or regional markets are increasingly spilling over globally and across asset classes.

While much of the talk is about the US/China trade war, markets have been further stressed by Argentine elections leading to a 28% decline in the Merval index, Hong Kong demonstrations leaving the Hang Seng down 8.9% during August, crude oscillating between fears of recession and Iranian activity in the straits of Hormuz, Brexit’s continuing effect on sterling, and Italian election fears causing sovereign spreads to widen.¹ Events such as Argentina can spill over quickly into other emerging market assets as investors cut risk.

The aggregate effect has been a rush to buy bonds, an increase in implied volatilities across asset classes and weakness in global equities with concerns that the “next” event could be the proverbial straw that breaks the camel’s back. As investors grapple with the odds of recession and more accommodative central bank policies, they may also need to consider the impact of increased volatility and these cross asset dislocations on overall portfolio construction. In our view, this may all suggest the need to reduce gross exposures if cross asset volatility spillovers persist.

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As of 15 August 2019.

With contribution from: Henry Neville (Man Solutions, Analyst) and Peter van Dooijeweert (Head of Institutional Hedging, Man Solutions).

1. As of 15 August 2019.