Despite all the headwinds, most economies in the developed world are performing well. Everyone who wants a job, has a job. Unemployment hasn’t been this low for nearly 50 years. And spending is strong despite households paying more for everything. Things are good, right?

Why then have our investment portfolios dropped since the start of the year? What is ‘Mr Market’ seeing that isn’t obvious to the rest of us[1]?

The answer to that question lies at the heart of investment 101 - investment markets are looking ahead, a year or two, and they see a slow-down coming, a recession, meaning lower profits for businesses. Hence those businesses are not worth so much today.

How can Mr Market be so sure a recession is coming? What can she see that we can’t?

Something to do with inflation and interest rates rising? If you thought that, you would be right.

Mr Market is watching interest rates going up, and the fear is ‘higher for longer’, and when interest rates go up it makes the chance of a recession more likely.

Rising interest rates squeeze anyone with debt. Less money to go around as more money is going to pay interest. Some people lose their jobs, their houses, their businesses. A dreadful crisis for some at the margin, but manageable for the country as a whole.

But the Market has her eye on other things as well, on things that might indicate whether interest rates are going to be higher for longer, or, perhaps not so high for not so long?

‘Leading indicators’, as they are known, tell us about developing trends. The data that tells us whether business activity is slowing down, whether spending is slowing, whether goods are starting to accumulate in warehouses, whether ‘Sales’ are needed to move products in the shops, whether unemployment is rising, whether mortgages are coming off low fixed rates onto higher rates, whether manufacturing companies have slowing orders coming in for their products, whether house prices are falling, and so on.

When the Market sees those things pointing in the same direction: that economies are slowing down, that unemployment is rising, and spending has actually reduced, then Mr Market gets very excited, very emotional, and share values and bond values rise. Our diversified balanced portfolios get a boost from both sides of the growth/defensive divide, from rising share values and rising fixed interest values.

The market is loving seeing high interest rates doing their job, bringing spending back into line with supply, because it leads to a reduction in inflation and therefore a pause in the rise of interest rates. Potentially even interest rates starting to come down again!

We saw that start to happen late last week in the USA, when inflation figures were slightly lower than expected for the month of October. Share and bond values took off, but then the rally ran out of steam after the head of the Federal Reserve came out and warned, “not so fast, we haven’t stopped raising interest rates yet. There is still more work to do on inflation”.

Many pundits around the world are convinced that inflation has peaked. The leading indicators are showing that to be true. It is now just a matter of time for this tightening cycle to end.

Reserve banks will tighten for too long. They must make sure the message has had an impact as the risks for underdoing it are worse than the risks of overdoing it. Reserve banks are predicting that they will eventually have to lower rates after the tightening cycle.

Recession?

Should we be worried about the coming recession?

I don’t think so. We probably need a recession to finish off the battle against inflation. Part of the “overdoing it”. There is no other way to achieve the result we need. It will be a devastating problem for those households that lose their jobs/houses/businesses, but this won’t impact the vast majority of us.

How hard will the recession be, is a better question? And how will we know we are in one?

There is no one definition of what constitutes a recession. It is not a legal or scientific term. It comes down to an opinion. Some define it as two quarters in a row with negative growth. Others say that we are in a recession when unemployment rises by 1% or more.

New Zealand’s current unemployment is at 3.3% which is historically very low. If it rose to 4.3% it would still be very low, but that would still constitute a recession.

In the meantime, be thankful that your investments are well diversified and poised to recover, once markets can see interest rates peaking, even though we may be in the middle of a recession.

Patience is all that is required. Any other action is likely to have a 50% chance of failing, and those are not good odds to play.

As always, if you have any questions or concerns give us a call. We are keen to help.

Keep asking great questions … 

[1] The term ‘Mr Market’ was coined by the father of value investing, Benjamin Graham, in his famous book The Intelligent Investor, back in 1949. At that time gender issues weren’t prevalent, and everything was male dominated.