It will be the Fed, not China, that throws us into recession again
Throughout my career in fund management there has been one truism that has been consistent: equity bear markets arrive in anticipation of, or as a result of, economic recessions, and economic recessions are caused by higher interest rates. If you overlay the chart of the Fed funds rate with US economic recessions, there is a 100 percent fit.
The reasons for raising rates, and the amount they are raised may differ between cycles, but the outcome is the same. This strong and well-established correlation between both interest rates and economic growth, and also monetary aggregates and asset prices, has understandably swelled the ranks of Fed watchers over the years.
I therefore believe if the Fed raise rates any time soon, the outcome will be the same as after previous rate rises: economic recession, and the turning of the recently started correction of equities into a full equity bear market and a corresponding rally in government bonds, despite the latter’s already heady valuations.
If the Fed raise rates any time soon, the outcome will be the same as after previous rate rises: economic recession.
Equity bulls, such as Morgan Stanley with its recent ‘full house’ buy alert on equities, counter that equities are cheap relative to bonds, corporate earnings are rising and the economic fundamentals remain sound, so the bull market should resume.
Obviously what we don’t know at this stage is whether the Fed will actually raise rates or whether just talking about it has blown sufficient froth off markets to allow them to postpone yet again. Bear in mind they have been talking about it for some years.
We can speculate endlessly about what might tip the balance one way or another, but the simple fact is they haven’t decided yet. And lots of smart people don’t agree on the outcome. The Fed watchers at the IMF are urging caution, arguing “risks are tilted to the downside.” In contrast, Bill Gross argues it will be too little and too late if, and when, they act.
However, I think there are a couple of dynamics this time round which will have a big bearing on the outcome. It is well accepted and, therefore, uncontroversial to say the current monetary and economic cycle differs from previous ones for two main reasons: first, the widespread adoption by central bankers of QE post the 2008 financial crisis and, secondly, the very substantial growth of the Chinese economy, both of which have had a very benign impact on global economic growth, inflation and corporate earnings.
After swelling their balance sheet through QE, the Fed stopped in 2013 and then suggested they might retire some of the accumulated debt, which led to the first ‘taper tantrum’, and a re-evaluation of the strategy which resulted in reinvesting the proceeds of maturing bonds. Many commentators argue it doesn’t matter that the Fed has an enlarged balance sheet and, also crucially, that shrinking it will have little impact. In other words QE was a free lunch or a free force for good in helping the economy along when it needed it and will have no negative impact on reversal.
Stopping QE will I think, with hindsight, be seen as the equivalent of the first rise in interest rates in a normal cycle.
I find that difficult to accept. Markets operate at the margin and it is the rate of change rather than the absolute level that is important, particularly the rate of change of liquidity and corporate earnings. Stopping QE will I think, with hindsight, be seen as the equivalent of the first rise in interest rates in a normal cycle. Reversing QE will be the equivalent of a second or third rate rise. If this coincides with an actual rate rise, the impact will be very significant.
The second dynamic of Chinese growth, and associated volatility in their stock market, is less likely to have long-term implications for the rest of the world’s financial markets as Chinese financial markets are nothing like as important to the rest of the world as the size of their economy might suggest. Slowing trade with China will impact non-Chinese corporate earnings, but will be combined with a deflationary push on commodity prices which should, in time, help consumer spending elsewhere.
It is only after the Fed raise rates that we will begin to be able to judge just how precarious the current economic fundamentals are but — and I’m repeating myself here — should they do so, I am convinced the equity market correction will turn into the next bear market.
Gregor Logan is an independent investment management specialist and investment commentator. He previously held leadership roles at Fidelity Investments, Pavilion Asset Management and New Star Asset Management. He has written about the impact of QE on the UK election, the effect of online investment platforms on the traditional asset management industry, and the difficulty of unwinding QE.