At the global equity market peak last year, financial assets were strongly outperforming the real economy, a state we refer to as bearish divergence. At the time, World Wealth was 2 standard deviations above its long-term trend, while global industrial production was only 0.47 standard deviations above trend (Figure 1).
That gap has now been closed, which by implication suggests that most of the adjustment has been in equity multiples rather than in expectations about future earnings. And for the US at least, it is only in the last few months that consensus revenue and earnings projections have started to soften. And so far not by very much.
Just in the last few weeks, as (global) bond yields have risen aggressively and bearish sentiment in equity markets has soared, World Wealth has started to undershoot the real economy.
In fact, if you look at indicators like the Bull/bear ratio in the US, equity sentiment is already at levels that tend not to be sustained for any length of time except during actual recessions.
So in short, it feels as though investors are increasingly seeing recession as baked into the cake (which is not to say that the impact on earnings is fully discounted as yet).
There is some symmetry here: part of the rationale for the divergence between financial asset pricing and the real economy late last year was the hope that the exit from COVID restrictions everywhere except China would unleash a period of re-accelerating growth, led by the service sector, that would in turn coincide with reduced supply chain pressures and some clear declaration in inflation. Now the perception is that the Fed’s hyper-hawkish approach to monetary policy, aided and abetted by the Putin inspired energy squeeze in Europe, virtually guarantees a (significant) recession.
Enter another perception gap. As things stand, the global economy is subsiding into stagnation rather than crashing. But that is the net effect of parts of the good sector (and housing) seeing outright declines in demand (and the first signs of disinflation or deflation) while the service sector has been recovering just as people expected it would once COVID fears and restrictions faded away. (Figure 2)
That’s all the more remarkable given that in most leading countries measures of consumer and business sentiment are already as gloomy or gloomier than they normally get during actual recessions! (Figure 3)
Such is the post-pandemic labour shortage that firms are mostly still trying to hire workers despite having a gloomy outlook for demand, and while layoffs have edged up they are by no means galloping upwards as they typically do during recessions. And even in the goods sector, firms are not as yet slashing inventories is aggressive fashion.
On the consumer side, housing activity has gone into a nosedive, consumers have become more value conscious about everyday purchases, household appliance and tech sales are weak but restaurants and bars are full and travel and leisure activity robust.
Full scale retrenchment is almost nowhere to be found.
Is that about to change as consumer spending habits re-converge with sentiment?
In the shorter run, energy prices are a potential catalyst. In the US that means gasoline prices at the pump especially, in Europe that means natural gas and electricity prices in particular.
The former have stopped falling but not jumped as yet; the latter are breaking down as inventory levels build up impressively (Figure 4, Figure 5).
Which is a way of saying that the perception gap between sentiment, spending and hiring decisions in the real economy can remain unusually wide for a little while yet.