Investment Thesis

For investors holding a long position in popular indices like the S&P 500, the Dow Jones Index (DJI) or the Europe-focused STOXX 600 during the last decade, their investments unarguably paid off very well. However, dark clouds on the horizon indicate an end for this trend.

Of course, the initial indications of an occurrence of a recession do not emerge when the economy is at its bottom, but rather, they emerge when the economy is running at a higher rate than its long-term trend line, which is known as potential growth. Current global growth projections of 3.9% for 2018 and 2019, respectively, exceed potential growth rates (IMF, World Economic Outlook Update, July 2018). The lagging growth of production capacities at some point in the economic cycle signals an overheated economic condition, which manifests itself in the form of increased inflation. In an attempt to contain inflation, central banks will raise interest rates, which will eventually lead to an economic downturn. The G7, which represents more than 30% of global GDP, has been in a steady growth phase for the last 114 months. In fact, only the 126-month run in the 90s (mainly caused by the rise of new technologies, low oil prices, collapse of the Soviet Empire, reduction of tax rates and the establishment of a trade agreement in North America) outperformed the current trend. At the same time, the current growth phase is at its all-time weakest when comparing the compound annual growth rates.

This article analyses various financial indicators with a particular focus on Europe and attempts to anticipate the consequences of entering a new stage of the business cycle. This article will provide helpful insight to those investors who are currently invested in passively managed funds (or investments with a strong positive correlation to economic cycles) by tracking popular indices like the S&P 500, DJI or STOXX 600.

US Yield Spread as a solid indicator  

The shape of the United States’ yield curve has always been a solid indicator of the state of the economy; whereas, the short-term interest rate is primarily influenced by monetary policy and the long-term interest rate is primarily influenced by the market. In regard to low short-term interest rates, monetary policy attempts to stimulate the economy. Simultaneously, the market (caring about real returns) charges a risk premium in the longer-term interest rate anticipating inflation (consistent with the liquidity premium). The result is an upward sloping yield curve indicating a bright economic outlook. Reciprocally, a downward sloping yield curve anticipates weakening inflationary pressure and a darker economic outlook. A method to visualize this effect is to calculate the spread of the 10-year Treasury Bond yield and the 2-year Treasury Bond yield. If the spread narrows, then an upcoming recession is indicated, as depicted in the graph below (due to the definition of the concept “recession,” the occurrence of a “recession” is lagging economic downturn).

Euro zone Retail Sales and Business Climate tumbling 

Consumer spending accounts for more than half of the European Union’s economy and can be gauged by Eurostat’s monthly published retail sales data. From that data, we determine that the year over year growth rate for the last 48 months is stagnating, and based on quarterly smoothed data, has been continuously declining for more than a year. Measuring market sentiment with the STOXX 600 Index (which includes European countries not having the euro as a single currency), we usually observe up and down movement going hand in hand with retail sales. However, the current downswing in retail sales has not been reflected in the price of the index (as per 1 Sept. 2018).

Meanwhile, the Business Climate indicator surveyed monthly by the European Commission has been continuously easing since the beginning of 2018. This indicator gauges the healthiness of the business cycle by representing industrial production in the euro area. Despite the fact that industries represent less than 25% of the GDP in the euro area, it is the most volatile sector, and therefore, is known as a good indicator of inflexion-points. Comparing this indicator with the FTSEurofirst 300 Index, which consists of the 300 largest companies ranked by market capitalisation in Europe (not just the euro area), the market has not reacted to the deteriorating business climate.

Halfmast on QE and massive balance sheet expansion 

After four years, the European Central Bank (ECB) is steadily winding down their large-scale asset purchase programme that was initiated in 2015 as a monetary stimulus. The monthly net purchases for the first three quarters in 2018 were limited to 30EURbn and are projected to be reduced again by 50% in the last quarter of the year before being completely stopped at the end of the year. [1]

Consequently, the ECB’s balance sheet has grown. In fact, the share of euro-denominated securities in the euro area relative to the total balance sheet of the ECB has more than doubled since 2015 and now represents the bulk of its assets as of 31.12.2017.

Currently, the ECB does not intend to reverse its redemption policy; consequently, we expect maturing securities to be reinvested in an adequate but unspecified manner. The program will continue to support the market with the reinvestment flows generated by quantitative easing (QE), which are effectively reducing bond volumes available to the private sector, and therefore, represent a lid on bond yields. The projected stop of APP (asset purchase programme) net purchases at the end of 2018 and low reinvestment flows (especially in the corporate sector) in February 2019 could tighten refinancing conditions, and therefore, spark the markets and increase bond yields, which would adversely affect the stock market. In a later stage, an attempt to shrink the ECB’s balance sheet will logically accelerate the soaring rise in bond yields even further.

The Federal Reserve and the ECB held interest rates low at record levels for an unprecedentedly long time and while America has begun to raise interest rates, Europe is most likely holding to its low-interest rate policy for at least the next two quarters. Historically, the US has had multiple recessions followed by interest rate hikes from central banks. It remains to be seen how the European economy will react to upcoming interest rate hikes. 

The four most dangerous words in investing

In memory of John Templeton, who remarked that the four most dangerous words in investing, “This time it’s different,” we are not advocating for a panic-filled reaction to our article. We do decisively state, however, that multiple indicators are pointing to a correction in the financial markets and, by acting accordingly, investors could spare themselves some sleepless nights.

Disclosure: we have no positions in any indices mentioned, and no plans to initiate any positions within the next 72 hours. We wrote this article ourselves, and it expresses our own opinions. We are not receiving compensation for it. We have no business relationship with any company whose stock is mentioned in this article.

1. https://www.ecb.europa.eu/press/pr/date/2018/html/ecb.mp180614.en.html