Despite noting that current US financial market pricing does not signal expectations of recession, Patrick Saner, Head Macro Strategy within Group Economic Research and Strategy at Swiss Re, still anticipates a US recession later this year.
Saner highlights the fact that the global economy and financial markets have been struck by an array of bad news over the last year, noting that “Recurring inflation scares, the fastest monetary tightening in over 40 years and recession fears have contributed to substantial volatility.”
Yet, according to Saner, markets are largely pricing in a “fair weather” scenario, one in which economic growth decelerates, inflation pressures gradually abate and central banks can look to start easing policy again.
Saner writes, “Market pricing, however, conveys little about underlying vulnerabilities. The UK liability-driven investment (LDI) crisis last year and recent bank-related stresses are but a few examples showing that the interconnectedness of markets is not always transparent.”
He continues, “What’s more, market functioning is often impaired in times of stress, exacerbating volatility when it is least desired.
“In the context of 2023, that is with our expectation of more monetary policy tightening and recession in the US in the second half of the year.”
Swiss Re states that many measures of functioning suggest that financial markets are currently prone to sudden volatility spikes.
The firm cites the Bloomberg liquidity index for US government bonds, which provides an overall gauge of the underlying health of the US Treasuries market.
According to Saner, the index has recovered somewhat from recent stress episodes, but it remains structurally higher than in the past, suggesting that market functioning has become “more patchy.”
Meanwhile, Saner says that measures of the USD credit market functioning show that both investment grade and high-yield bond market functioning appear to have deteriorated.
He writes, “Average daily trading values have decreased over the past years, and primary dealers are warehousing less risk.
“This means that these markets will struggle more than in the past to efficiently facilitate risk pricing. In addition, the CBOE Volatility Index (VIX) – which measures implied equity market volatility – is currently at its lowest in about 15 months.
“We continue to expect a mild recession later this year and hence markets are prone to repricing of macro risks.
“But even without a recession, markets have structurally become more prone to “gap risk”, that is sudden price jumps that accentuate volatility in times when smooth market functioning is most needed.”
Saner adds, “Current market pricing across assets is relatively benign. Interest rate futures price a little over 100bps of Fed cuts over the next 12 months towards a more neutral policy stance, contrary to our expectations of no cuts during that time.”
“1-year forward equity earnings expectations have come down to roughly 0% but do not reflect recession expectations. Neither do standard equity valuation measures where the forward P/E is at 18.4 compared to the median forward valuation of 13.8 during recessions. Likewise for credit spreads, which are broadly in line with historical non-recession averages.”
Saner concludes, “Yet, given how unusual this economic cycle has been, and the lead and lag times of monetary policy amid the fastest hiking cycle in decades, in our view times of market volatility are far from over.
“Our baseline scenario of US recession in the second half further supports our view. Insurers are long-term investors and financial market volatility with liquidity gap risks underline the need for disciplined balance sheet management.”
