Just five weeks into the new year, stocks have taken a beating across the globe. Continuing a trend we saw beginning in early 2015, stocks of a small number of very large US companies have been the best place to be. Almost everything else -- US small caps, other developed market stocks and emerging market stocks -- has done poorly, with many segments already in bear market territory.
And, after initially reflecting concerns about the impact of the enormous decline in oil prices, spreads on high yield bonds have continued to widen across industries, reaching normal recession levels. Even spreads on high quality US corporate bonds have now reached a level typically associated with recessions. Conversely, investors have flocked to the perceived safety of US Treasury Bonds, driving yields down and prices up very significantly.
All of these market reactions are classic signs of an impending recession. However, we are missing some typical ingredients. First is that the yield curve usually inverts (short term rates higher than long term rates) ahead of recessions. This will be hard to achieve with short term interest rates so low and, with the markets having tightened financial conditions, it seems very unlikely that the Federal Reserve will raise rates further this year.
Second, the US consumer needs to stumble. So far, consumer spending has been very consistent if not spectacular. Consumer leverage is low and the employment market still seems to be on solid ground. Indeed, the most recent reports on jobs show good wage growth, longer work weeks and strong openings. Only initial jobless claims are a bit weaker than expected -- something we need to keep an eye on.
Finally, we are missing high oil prices, another common ingredient in the recession recipe. Near term prospects for price increases seem pretty dim as inventories are very high, weather is mild, demand is growing modestly and supply continues at a high level. Of course, cutbacks in capital investments and employment in the energy sector will continue to be a drag on growth here in the US.
All of this said, we believe the risk of recession continues to rise. Economic growth in the US is weak by historical standards (although our belief is that 1.5 - 2.0% growth is the rate we should expect based on workforce growth and productivity trends), leaving us little cushion to absorb shocks.
Persistently low oil prices raise the risk of shock from several sources: geopolitical conflicts, bank credit problems and adverse credit market events. And we have to add into the mix the impact of a slowing China, particularly on capital flows and currencies throughout that part of the world.
Bottom line, the markets have real reason to worry so we are remaining somewhat cautious in our investment stance for client portfolios. We continue to add to hedged strategies in pursuit of reasonable returns at moderate risk.