Market Outlook

Stocks and slowdowns: how to manage recession fears

China’s headline GDP rate in the third quarter was an annualised 6%. In most parts of the world, such a growth figure would be described as stellar. But for China, it marked the slowest pace of economic expansion in nearly three decades. The Q3 number was down from 6.2% in the previous quarter and far below the 6.5% achieved in Q3 2018.

One of the key factors behind China’s slower growth has been the lengthy trade war with the White House, as President Trump tries to rebalance the US’s trade terms. This protectionist trade policy has, in turn, damaged the US economy and raised fears that it could spark a recession next year in the world’s largest economy.

However, the US and Chinese economies are not the only ones facing challenges. The manufacturing slump in Germany – Europe’s powerhouse economy – has left it on the brink of recession amid worries about the negative impact of the UK’s exit from the EU – which will have an affect not only its own economy but also on the bloc’s.

 

Facing facts

Some economists and analysts are pointing other reliable indicators of a looming recession. The International Monetary Fund, in reference to the UK’s £15 trillion corporate debt mountain, warned that “surges in financial risk-taking precede economic downturns”.

Earlier this year, the inversion of the US Treasury yield curve – when the 10-year Treasury bond’s yield falls below those of short-term notes, such as the two- and three-year bonds –also caused some panic as such an inversion has preceded all post-war recessions.

“The inverted yield curve is certainly the most critical signal to predict recession. Looking at the two-year five-year spread, the track record in predicting recessions is about 80%,” said Christopher Dembik, head of macroeconomic research at Saxo Markets.

“However, an inverted yield curve does not mean a recession is imminent. Based on the previous decades, it takes an average of 22 months for the recession to happen after the inversion of the yield curve.”  

“However, an inverted yield curve does not mean a recession is imminent. Based on the previous decades, it takes an average of 22 months for the recession to happen after the inversion of the yield curve” - Saxo Markets head of macroeconomic research Christopher Dembik

 

Best case scenario

Despite some of the indicators, not everyone is convinced that a recession is looming.

“The PMI business confidence data are probably the best up-to-date indicators of the direction of global growth. In the Eurozone and the UK, they are still heading in the wrong direction, although are not yet at levels pointing to a recession,” Rupert Thompson, head of research at Kingswood told Opto.

“In the US, the picture is confused because the ISM indices, which like the PMI numbers measure business confidence, are painting a rather different picture to the PMIs. According to the ISM numbers, business confidence fell sharply in September, particularly in manufacturing, which hit a 10-year low, while the PMIs held up much better.”

Thompson said the October releases will give a clearer picture in the US, but he remains optimistic.

“We believe consumer spending should remain reasonably well supported by the labour market and the weakness in manufacturing should be contained. Indeed, in time we expect growth should recover a bit as Fed easing feeds through and US-China trade tensions slowly ease,” Thompson added.

He is also unconvinced by concerns raised by the inversion of the yield curve.

“Yes, in the past it has been one of the best predictors of recession,” he noted. “However, we believe quantitative easing has distorted the yield curve and that this time round the signal is as a result much less reliable.”

“However, we believe quantitative easing has distorted the yield curve and that this time round the signal is as a result much less reliable” - Kingswood head of research Rupert Thompson

 

Indeed, analysts have pointed out that the yield curve was flat for most of the early 1990s and even inverted in 1998 without a recession.

 

Assessing the risks

Although other factors suggest that a recession could still be far off, that doesn’t mean recession risks should be ignored. Amid what the IMF terms a “synchronised slowdown” in global growth, there are unique financial vulnerabilities that have emerged in the post-financial crisis era, which require concerted efforts by governments to resolve – something that looks difficult to achieve when political divisions and populist sentiments are rife.

Looking at the US economy, GDP was only 2.1% in Q2, down from 3.1% in previous quarter. For 2019 as a whole, GDP is expected to be around 2.2%, down from 2.9% last year. US growth is not going in the right direction, but it’s certainly not yet in recession territory.

Investors and traders who are nervous about the “yet” in the preceding sentence have a range of measures at their disposal to manage the uncertainty.

John Hardy, head of FX Strategy at Saxo Bank Group, advises traders to keep their exposures appropriate to volatility. “In bear markets, recognise that trading range can expand to multiples of the average recent volatility. Appropriately scaled positions will allow traders to stay in the market sufficiently long to be proven right or wrong.”

He advocates using options like long puts and call spreads to “maintain a position and have a degree of distance to the risk of wild swings in markets”.

“In bear markets, recognise that trading range can expand to multiples of the average recent volatility. Appropriately scaled positions will allow traders to stay in the market sufficiently long to be proven right or wrong” - Saxo Bank Group head of FX Strategy John Hardy

Traders should also keep some funds in reserve for excessive pessimism. “One longer-term strategy is to slowly raise allocations to risky assets like equities if declines accelerate in parabolic fashion; market turns inevitably happen when things can’t seem to get any worse,” Hardy said.

“In addition, in a steady, grinding bull market marked by stolid, boring appreciation driven by steady investor inflows, technical analysis offers less predictive value as the self-evident trend is clear for everyone to see. But in bear markets, when liquidity is poor, and emotion is high, technical analysis can yield more useful observations.”

Thompson meanwhile said investors need to bear in mind that geopolitical risks remain on the high side, as do risks related to the US-China trade war. “We recommend investors should retain some protection in their portfolios in case downside risks materialise. An allocation to gold, which has performed very well this year, continues to make sense for this reason,” he considered.

“Bonds also can offer protection, but investors should be wary of long-maturity bonds, as at the current very low level of yields, there is the risk of significant losses if yields were to head higher again.”

“Bonds also can offer protection, but investors should be wary of long-maturity bonds, as at the current very low level of yields, there is the risk of significant losses if yields were to head higher again” - Saxo Bank Group head of FX Strategy John Hardy

Investors should also be thinking about a global recovery. “This will set the scene for renewed gains in equities and significantly higher returns from equities than bonds. This, in turn, means investors should have a significant equity allocation in their portfolios,” Thompson said.

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