The UK General Election in July sailed through without even so much of a bump in markets. When it comes to politics, attention now turns to the US presidential election and who will control Congress. I’ll touch on the potential implications of the US election for investors in the last section.
It wasn’t politics that spooked markets in the third quarter, but recessions and the yen carry trade. As a quick primer, a carry trade involves borrowing in a country with low interest rates and investing the proceeds in another country where yields are higher. Therefore, investors borrow a low-interest currency – such as the Japanese yen – and sell it to buy a higher-yielding foreign currency to then invest in assets denominated in that currency. Investors profit from the difference between the higher returns on their investments and the lower borrowing costs, assuming the currency exchange remains stable. Due to Japan’s very low interest rates, investors have sold large amounts of Japanese yen to invest abroad. Some estimate the amount to be into the trillions of dollars, with significant leverage involved. Consequently, when the Japanese yen strengthened in early August, it triggered significant volatility in asset prices as investors rushed to unwind their yen carry trades. And when leverage is involved, many traders become forced sellers, which perpetuates the fall in asset prices.
Alongside this volatility, market pricing also suggested that recession risk has returned. It was a sudden shift in focus as investors deemed a recession as the greater concern over that of rising inflation. This is significant given where we are with central bank interest rates across Europe and the US as they are at a level that is intended to restrict economic activity.
Therefore, the key topic for this quarter is one of recession and central bank response to this potential risk. Then for multi-asset investors, how we can mitigate this risk in portfolios.
Predicting Recessions
Predicting recessions is hard. Many people try, and many people fail. Even the stock market gets it often wrong, leading to the old saying that the stock market has predicted nine out of the last five recessions.
Only back in November 2022, the Bank of England warned that the UK was facing its longest ever recession since records began. Specifically, that the country entered a downturn in the summer of 2022, and it was expected to last until the first half of 2024. This prediction came with an expectation that the unemployment rate would double by 2025. Figure 1 shows what actually happened over this time period.
Figure 1: UK Gross Domestic Product (GDP) growth on a quarterly basis from 2019 showing the pandemic recession and the shallower recession at the end of 2023. A recession is defined as a sequence of two or more quarters of negative growth.
The scale of the pandemic-induced recession does skew the above chart due to how much the UK economy contracted in the second quarter of 2020. However, the Bank of England’s prediction for a recession starting in 2022 was not for it to be this deep, but for the recession to last longer. We now know the UK did enter a recession back in the third and fourth quarters of 2023, which is just about visible in Figure 1. Although this certainly isn’t the longest recession on record. For reference, the recession during the financial crisis of 2008/09 lasted for five quarters.
The Bank of England also expected the unemployment rate to double by 2025, which would result in a rate of unemployment of about 8%. Figure 2 suggests that this is not likely to happen, at least in the next three months. Again for reference, the last time the UK experienced an 8% unemployment rate was during the financial crisis and its aftermath.
Figure 2: The unemployment rate from the end of 2018. The rate of unemployment would have to increase significantly in the coming quarter to reach the Bank of England’s 2022 prediction of it doubling by 2025.
Many economists, business leaders and media outlets were forecasting recessions to come during 2022, so the Bank of England was not alone. Indeed, the ‘hard landing’ versus ‘soft landing’ analogy that has permeated market debate for over two years now stems from recessionary predictions; a hard landing is one where a central bank brings inflation under control but with a consequent recession, whereas a soft landing avoids the recession altogether.
Thinking back to the bout of volatility in August, it was, in part, caused by another recessionary signal known as the Sahm rule, as related to the US labour market. It states that when the three-month moving average of the US unemployment rate rises by 0.5% or more over the minimum of this…
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