The apparent contradiction between the real economy and financial markets has surprised some commentators, but is normal around the peak of the business cycle.
Economic data reflects current conditions while financial prices reflect how traders expect the economy to develop in the future.
By definition, every downturn starts from the top of the business cycle when activity is high. The rapid transition from strong and growing economic activity to recession is what makes it difficult to predict turning points.
In recent decades, the biggest forecasting errors have occurred around turning points, especially peaks (“Business cycles: theory, history, indicators and forecasting”, Zarnowitz, 1992).
But the financial markets now believe there is a high probability of a significant slowdown in the economic cycle in the next 6 months, which may be classified as a recession, despite the high level of economic activity and jobs.
World trade volume and industrial production remained at or very close to record levels in June, according to the Netherlands Office for Economic Policy (“World Trade Monitor”, CPB, August 25).
U.S. freight volumes were at record levels in June, and manufacturing output was near its highest level since before the financial crisis, based on data from the U.S. Department of Transportation and the U.S. Federal Reserve.
Manufacturing activity continued to increase through August, albeit more slowly than previously, according to surveys by the Institute for Supply Management.
The ISM composite PMI stood at 52.8 in July and August, just above the 50-point threshold that separates growth from contraction, and in the 50th percentile for any month since 1980.
But a wide range of financial indicators from bond, stock and commodity markets, as well as individual share prices for bellwether companies, all point to a significant slowdown in the cycle over the next six months.
Futures indicate the US Federal Reserve is expected to raise interest rates over the next six months to 4.25-4.50 percent by April 2023 from 2.25-2.50 percent currently, shocking borrowers and the economy.
The U.S. Treasury yield curve between two- and ten-year maturities is inverted at any time since the dotcom bubble burst in August 2000.
Financial conditions are tightening at some of the fastest rates in more than a decade, according to the Chicago Fed’s Financial Conditions Index, which is based on measures of risk, credit and leverage.
U.S. stock indexes have already fallen as investors expect the downturn to hit demand and drag more of future earnings.
After adjusting for inflation, the broad US S&P 500 stock index is down 13-14 percent year-over-year.
Individual stocks closely linked to the cycle, including Caterpillar, the heavy equipment maker, and 3M Corporation, the diversified manufacturer, have fallen sharply, in line with the sharp economic slowdown.
South Korea’s KOSPI-100 index, which tracks global business volatility due to heavy exposure to export manufacturing companies, is also down more than 23 percent from the same time last year.
The expected slowdown in the economic cycle is evident in fuel markets, where the spread between European gas oil and Brent crude futures for delivery in April 2023 has narrowed to $30 a barrel from more than $40 at the end of August.
The calendar range for natural gas between December 2022 and December 2023 has fallen to $12 a barrel, back from $26 in late August and $33 in June, indicating that inventories are expected to be higher than before.
Gas oil and other middle distillates are the workhorses of production and freight transport and are the most sensitive to changes in the business cycle.
Softer pressure is consistent with a regional and global slowdown that would allow distillate stocks to rebuild from their current severely depleted levels.
The prices of bonds, stocks and commodities reflect what is expected to happen, not what will happen – and those expectations may change or turn out to be wrong.
But financial markets are giving an unusually high probability of an impending recession at the moment so expectations cannot be dismissed.
Should a significant recession occur, it is likely to be more severe in Europe and China than in the United States.
Europe is directly affected by energy prices, high inflation and the potential disruption of gas supplies resulting from Russia’s invasion of Ukraine.
China is grappling with an ongoing cycle of city-level lockdowns imposed to stop the spread of the coronavirus as part of its epidemic control plan.
But the impact from Europe and China, as well as the massive tightening of financial conditions at home, is expected to lead to a significant recession in the United States itself.
Slower growth in the Big Three will also spill over into larger emerging economies, including India, Brazil, Saudi Arabia, Indonesia, Turkey, Mexico and Thailand.
If the expected slowdown materializes, energy use will grow much more slowly in 2023, taking some of the heat out of coal, gas, diesel and crude oil prices.
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