In terms of the market reaction, do you think it’s roughly in line with where you would expect that to be?
It’s always difficult to know what markets are discounting at any given time. As investors, we’re always trying to figure that out to find out if there’s an opportunity to lean against where the markets are positioned. Our general sense is that the market shifts have been consistent with the developments of the past weeks. Most intuitively, banks have been under the most stress, because they’re obviously at the epicenter of the crisis.
In broader equities, we think that the decline has been relatively orderly and modest so far. The S&P 500, for example, is down about 2-3% from just before the onset of the banking turmoil, which seems consistent with the relatively modest drag in estimated GDP growth that I mentioned earlier.
Now, some people have made the argument that broader equity markets should be down a lot more. But we think it’s important to keep in mind that the S&P 500 was already in a double-digit drawdown from last year’s peak when this recent banking stress began.
One way that we try to calibrate where the market is and whether that’s reasonable is to consider that in a typical recession, the equity market is down about 30% on average. At its current level, the S&P 500 is down about 17% from its peak. That’s about midway to a recessionary outcome, implying the markets may be putting about even odds on a recession. That’s consistent with the range that we have for recession of around 45 to 55%. So to us, the market is putting elevated, but not overwhelmingly large, odds on a recession.
What are the signals from outside the stock market telling you?
Outside of equities, there are areas where we see a bigger divergence in what the market seems to be pricing, and I think the most obvious candidate is short rates in the US. Here we’ve seen the US market go from pricing 100 basis points of additional hikes to almost a 100 basis points of cuts by the end of the year. Not only is that 200-basis-points-swing in one week highly unusual by historical standards — it’s just a very large move — but that nearly 100 basis points of cuts by the end of the year would also seem to imply growth outcomes that are much worse than what is apparently embedded in equities.
So the jury, in our mind, is still out as to whether fixed income has moved too quickly or equities have moved too slowly. But given equities seem to reflect better than even odds of a recession and that technical factors in the bond market likely amplified the move — you had extreme short-bond positioning among investors before the recent bank stress began — we would give the edge to the interpretation that the fixed income markets may have moved beyond what is justified by fundamentals. The move higher in yields from their lows at the beginning of the week also lends credence to that view.
The last point I would add on that dimension is that there is precedence for the Fed to cut rates outside of recession. For example, the Fed did cut rates in response to shocks in the 1990s, namely the rapid rise in bond yields that we saw in 1994, and then again during the Asian Financial Crisis and the Long-Term Capital Management Crisis in 1998.
So that might be another way to square the bond market pricing of cuts without necessarily implying a recessionary outcome.
