Bond markets across a number of developed countries including the US, UK and Germany are currently pricing in a recession. Global stock indices are close to, if not at, all-time highs. What exactly are the capital markets trying to tell us about the state of the economy?
Stock prices are a well-known leading indicator of the business cycle and future economic growth. They are among a handful of leading economic indicators (LEI) that analysts typically follow when trying to take an overall reading on economic activity. Stock prices have been on a winning streak this year, with Global equities as measured by the MSCI World TR Index AUD up 16% over the 6 months to 31 July 2023. The rally has been led by the US where the launch of artificial intelligence technologies such as ChatGPT, has created enormous buzz and excitement around potential productivity gains and outsized future earnings of companies across the tech value chain.
Bond markets, on the other hand, are taking a much dourer view. Taking the 10-year to two-year Treasury spread, yield curves in the US, UK and Germany are currently inverted. In Australia, the yield curve, while not yet inverted, is flat by historical standards. Inverted yield curves are typically good indicators that recession looms. Inverted yield curves reflect the expectation from bond investors that longer-term interests will fall; a situation typically associated with recessions.
So are bond or equity investors right? Inverted yield curves, while pretty reliable indicators, can and do give false signals from time to time. Equity markets too, can be prone to over-optimism, often overshooting fundamentals based on sentiment. Weighing the conflicting signals, our view is that we are headed for a period of weaker growth. The equity market rally to date has been narrow and centred around US mega tech stocks. Should we see greater breadth and participation in this rally, we may have cause to reconsider. Putting stock prices aside, most other leading indicators are pointing to a further slowdown in the business cycle. Consumer sentiment is extremely low, housing starts are weak, money supply is tightening and Purchasing Manager Indices remain in contractionary territory. To us, these data points lead us to believe that the second half of 2023 continues to present some headwinds for the economy and risk assets in general.
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