The disconnect between markets and the economy and how to insure against it
The world economy is at the kind of turning point that occurs only once or twice in a generation. Fourteen years of quantitative easing, that fuelled an unprecedented boom in asset prices, has come to a juddering halt. The economy, after being put into the deepfreeze during the pandemic, roared back in 2021 only to be hit by supply chain disruptions, China’s Zero Covid policy and, finally, the invasion of Ukraine and soaring energy prices.
“The outcome has been viral inflation and aggressive central bank tightening”, says Kokou Agbo-Bloua, Global Head of Economic, Cross Asset and Quant Research at Societe Generale. That has triggered an equally aggressive market reaction: bond prices are down, credit spreads have widened and – unusually – equities have fallen in tandem as investors start to price in a global recession.
In the real world, however, that recession has not arrived, at least not yet. Granted, some countries, notably Germany and the UK, are seeing severe demand destruction. But most developed – and many developing – economies are being shored up by buoyant labour markets; corporations that have done much to repair balance sheets; and record excess savings among households – some 10% of GDP in the US and 7% in the EU. Meanwhile, those interest rate increases will only impact spending after a lag of three to five quarters.
“This has created a disconnect between the markets and the economy”, notes Mr Agbo-Bloua, with the markets having perhaps reacted too rapidly and investors now uncertain and confused as they wait for the transmission mechanism of monetary policy to catch up. The most likely result is continued volatility as this plays out.
The optimistic scenario is that the recession, if it occurs at all, will be shallow and short, which would justify the recent rally in risk assets we saw in July and August after a dismal first half of 2022 – the S&P 500 lost a fifth of its value between January and June.
Inflation to be more permanent?
But what if inflation takes longer to defeat than expected? There is evidence that it is becoming embedded in both wages and rents, which suggests it will be more permanent than transitory. That means interest rates will have to keep rising until price increases have topped out, leading to a longer and deeper economic contraction.
History – and, indeed, the capital asset pricing model – teaches that it is very difficult for equities to rally sustainably in such circumstances, argues Alexandre Fleury, Co-Head of Global Markets and Head of Equities and Equity Derivatives at Societe Generale: “Since the global financial crisis the winning strategy has been ‘buying the dips’. Now it feels like we should be ‘selling the rallies’”.
If that turns out to be the case, then investors face repeated cycles of hope and disappointment. A traditional 60/40% equity/bond portfolio is set to suffer badly as both its components underperform. Indeed, the strategy of being net long the stock market, which has worked for so many years, may no longer be appropriate.
Derivatives as a means to mitigate uncertainty
“One way for investors to protect themselves from uncertainty is to make greater use of derivatives”, says Mr Fleury. Futures and options – available on equities, rates or foreign currency – can be used to fix the broken correlation between bonds and shares; to enable diversification by adding other asset classes such as commodities or real estate; and to provide insurance. Regarding the latter, there are some strategies where investors can receive defined annual income plus capital protection from a stock portfolio as long as losses do not exceed a certain level. They sacrifice the upside, but even this can be built back in if they change their view of the future – derivatives cover for even large portfolios can be adjusted in a matter of days.
Swift action may indeed prove necessary if matters turn out even worse than an ordinary recession. Following 2008, governments and central banks co-operated to shore up economies and markets. But they are now diverging, with large fiscal handouts to protect the vulnerable against cost of living increases (following the already generous spending to combat coronavirus).
This will work against the rate increases of central banks, potentially forcing them to keep tightening monetary policy for longer than would otherwise be necessary and hence leading to a deeper recession. Ultimately, there is a risk that the monetary authorities lose credibility with markets, which is the first step on the road to a currency and national debt crisis.
Fortunately, we are still a long way from that point for developed economies. But the dollar’s strength against the euro and the yen is a worrying straw in the wind.
For further insights, professional investors wanting to know more about derivatives: join online on 13 & 14 October the Societe Generale & Risk Derivatives and Quant Conference. This year’s edition entitled “Solutions for Clashing Cycles and Inflationary Markets” has been designed to provide investors with unique insights on market shaping topics.