Would you like the good news first or the bad news? Sorry, it's a trick question as the news for both is the same: the economy is slowing down. It's good news as it will help the inflation pressures; however, the bad news is too much slowing, and we have a whole new set of problems. Slowing economic activity should not be a surprise. We, and just about anyone else penning market missives, have been referencing the coming slowdown. And it is literally what tightening financial conditions are trying to achieve – with slow growth and lower aggregate demand, inflation will fall [even with supply bottlenecks/war issues].
Canada just posted a multi-decade high CPI of 7.7% year-over-year, yet the market is already looking past inflation to slowing economic growth. Bond yields across the globe have abruptly changed course over the past week and moved lower. Credit spreads, which had remained largely contained during the bond market weakness of 2022, have accelerated higher.
With higher bond yields (rising year-to-date until this past week), wider credit spreads, equity market volatility, plus almost all central banks raising their overnight lending rates, there's no denying financial conditions have tightened significantly. 'Financial conditions' is a fancy catch-all phrase that attempts to capture how available credit is to investors and businesses, plus the cost of that capital. Numerous indices attempt to measure financial conditions – the chart below is the Goldman Sachs measure. Regardless of your favourite financial conditions measure, there is a strong correlation between changes in financial conditions and the equity market. Conditions get more relaxed, and markets rise; conditions tighten, and markets fall. And so far in 2022, conditions have been tightening.
Changes in financial conditions don't just make the markets move up and down; it makes the pace of economic activity change. However, it does not chart as cleanly because the economy's reaction time depends on several factors. For instance, tightening financial conditions with solid economic momentum often doesn't register for quarters or even years. Also, changes in financial conditions appear quicker in parts of the economy and slower in others.
This year, it's showing up very fast. Perhaps because rate hikes are coming at a time of slowing economic growth, an historical anomaly. Usually, rate hikes and tighter conditions come as the economy expands too quickly. This time, between consumers pivoting from goods to services and the removal of pandemic fiscal supports, the economy was cooling before the financial conditions began tightening.
The old economic rule of thumb was rate hikes, one of the key tools that impact financial conditions, don't impact the economy for a full year. But let's just say rules of thumb are not laws. Then again, with recent SCOTUS rulings, maybe laws aren't even laws anymore. Tighter financial conditions are having a faster impact than usual on economic activity.
The weaker economic activity will continue as the bite of tighter financial conditions digs in. This is good news for inflation, which is increasingly showing signs of topping and hopefully coming back down, raising the big question as to the timing of the next recession. Expect this recession talk to increase in the coming months but make no mistake, this is required to address inflation. Our confidence in central banks managing a soft landing is pretty low. Inflation makes the feat more difficult, as does the previous elevated pace of economic activity. Hard to manage a soft landing when you start at 10,000 feet (aka global growth was high in 2021 at 5.8%). But the timing of the next recession is very uncertain. Industrial activity remains decent, consumers continue to spend, and Asia is emerging from COVID lockdowns.
Investment Implications
The markets are in a bit of a manic phase at the moment and are certainly overreacting in multiple directions. While inflation risks may be starting to ease, recession risks are rushing in as a replacement. Meanwhile, markets have already priced in a good dose of bad news. 2022 is a tough year with the repricing of most assets. We continue to believe inflation is a bigger risk than a recession for the markets and as inflation concerns fade, markets could enjoy a decent reprieve bounce. We will save a deeper dive into recession risks for our 2nd half outlook.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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