Are we heading into a recession?” a friend asked me a couple of weeks ago and I was quick to give an opinion: “Starting with China, in an order of increasing likeliness, I’d say the US, non-commodity exporting developing countries, Europe and the UK. The UK is probably soonest to head into a painful depression,” I was quick to answer. As quick answers go, they are not based on known or knowable facts but a reflection of my own emotions.
Pundits, asset managers and the CEOs of big banks and investment vehicles are dispensing their wisdom in a similar fashion. They cannot know what will happen but shout at each other trying to drown out opposing views. It is difficult to see the wood for the trees, for everyone. But as experts go, they cannot lean back and admit to knowing nothing.
What we all can see clearly is a bout of inflation not witnessed for two generations. The last time prices went bonkers in a similar fashion was in the 1970s and 80s. I have tried to explain the multiple reasons for this in my last piece: starting with an explosive demand push after mandated lockdowns, we see “Greenflation”, “Chinaflation” and “Putinflation” – the cost push of energy transition, China’s zero-COVID policies and its communist-inspired common prosperity programme, and the shortages and dangers emanating from Russia’s invasion of Ukraine.
I’d wish to add the inflationary effects of an ever stronger dollar and the corresponding fall of most other currencies which force countries to import inflation.
And we can witness the universal answer of central banks to deal with this mess: they raise interest rates and shrink their balance sheets to increase the cost of money in an attempt to lower demand. Demand-induced price exuberance can be brought under control in a gradual fashion.
Imported inflation of the sort described above cannot. It is therefore necessary to engineer a crash if inflation is to be avoided at all cost. If no one buys anything goes the logic, prices will have to come down.
The notable exceptions are the Bank of Japan and Russia’s central bank. The BOJ, after decades of crippling disinflation is for now still doubling down on monetary easing and controlling the yield curve in the hope to get at long last some inflation back into their economy. As a result, the yen is losing its exchange value precipitously, increasing the inflationary impact of ever more costly energy imports.
And Russia, being awash with dollars derived from unhindered oil exports at ever higher prices has seen the rouble going from strength to strength. This is not only due to the energy bonanza. Capital controls, forced foreign currency conversion and sanction-induced import limitations have made the dollar a less desirable currency domestically. There is no use for the greenback if it cannot be used. The RCB can therefore ease financial conditions domestically, giving much needed support to the economy.
It is therefore necessary to engineer a crash if inflation is to be avoided at all cost- Andreas Weitzer
What we can also see clearly is the impact inflation, higher interest rates and uncertain future demand have on financial markets and hence on our retail portfolio. Stocks are falling. Having lost more than 20 per cent of their value, the US market is according to a somewhat arbitrary definition in bear territory. Future income expectations are sharply discounted, reducing the present value of shares.
Tech shares and start-ups which promise profitability in the future are hurt most. But fear of soon dwindling margins damage valuations of solid income earners like consumer goods companies too. The spectre of a possible recession has recently brought down even money coiners like oil and mining companies.
Bonds have followed suit. They lose in value as interest rise. Higher interest rates make both mortgages and rents more expensive, depressing the housing market. House prices are coming down, most prominently at the lower end of the price spectrum, and so does the value of commercial property. Both gold and crypto has proven to be anything but a reliable hedge against inflation. Holding cash is a losing proposition. Investors take flight in ever more obscure “alternatives”, like gemstones and collectibles.
Narratives vacillate between inflation fears and recession scare, between certain doom and a crisis on the way of bottoming out. Bond yields rise and fall on a daily basis now. So does, as a consequence of vacillating interest rates, the valuation of shares. Volatility is high, not only fuelled by disorientation but also by shrinking market depth. Data indicating market direction are contradictory, contributing to disorientation and opposing, quickly alternating bets. The 10-year US government bonds change yields by half a per cent within days, signalling worse inflation one day, and a likely recession the other.
While inflation seems to reach double- digit price rises any time soon, some items in the consumer goods basket are getting cheaper. A University of Michigan survey gauging “inflation expectations” tell of 3.1% inflation five to 10 years from now, and 5.3% over the next year, while consumer price inflation is measured at 8.6%. A broadly used measure of “expectations”, the “10-year-breakeven”, which subtracts inflation protected yields from unprotected 10-year-treasury yields signals 2.5% at the time of writing. Monetary authorities dismiss fears of a recession one day, but seem to reckon with it the next.
Stock market pundits scrutinising the history of market downturns are convinced that a rebound of shares after a 20 per cent drop can only be temporary, a “dead cat bounce”. Worse will come. While investing in bonds when interest rates are continuously hiked upwards is a losing proposition, some bond experts point to the shrinking yield differentials between stocks and bonds.
While US shares at current prices have an earnings yield of 5.3%, investment grade bonds are sold at a yield of 4.7% and junk bonds, deemed as risky as shares, yield already 8.6%. This view ignores worsening credit risk.
Looking at my own investment portfolio, there’s not much I can do. As always, I am fully invested, bereaving me of opportunities. Sadly, we retail investors cannot go short, which is a shame when I watch the yen changing course anytime soon. I nurse losses of 15 per cent by now.
A third comes from currency losses. The weak euro is weighing on my $US-referenced portfolio. A third comes from my Russian bonds which are nominally worthless. Losses on my other bonds are paper losses only, as I will hold them all to maturity. My share losses, albeit, are a reflection of the general malaise.
The extracting industry is less buoyant than a few weeks ago. Oil services companies were a losing proposition for years already, and a dearth of oil field investments and the loss of the Russian market is permanently depressing them. Fancy bets, like the fake truck maker Nikola or my wiped-out cannabis investment, will probably never recover.
What illustrates the current confusion of direction best is my European banking shares. While rising interest rates should in principle boost profitability, their shares are rightly showing the signs of weakness the whole eurozone encapsulates. The energy crisis, the labour crisis, and endangered demand is corroding profitability as is rising credit risk.
Banks will be hesitant to grant credit while they fear a worsening of credit standing of their clients. Nowhere is this more apparent than in the banks’ mortgage business. With rising credit costs, real estate lending will not only slow, but also accumulate losses rapidly. My shares in Lloyds, Bank Santander and BNP are a case in point. Their share price is an underestimated recession gauge.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com