Leverage heavily used, which means that investor capitulation is far off
On the stock markets, the reaction to the war between Israel and the terrorist Hamas, which began at the weekend, has been lukewarm. At the time of writing, oil prices had jumped a few percent. If the conflict does not escalate into a wider regional conflict, the impact will be temporary.
This graph shows the average development of oil prices over the last six Israeli-Palestinian conflicts. The sample is of course too small, but it gives a small indication of the limited impact of local conflicts on world markets. That is, if the conflict remains local.
In this post, let’s talk about how Finnish retail investors have a record amount of investment leverage at their disposal. In other words, people are not giving up on stocks but scooping up more shares with savings and debt. Then we look to the US, which is again showing long-term recession warnings.
Leverage heavily used, which means that investor capitulation is far off
Stereotypically, long stock market declines end in panic falls, where investors want to get rid of their shares at any price. At the bottom, we read in the news about leveraged investors whose portfolios are being sold off when stocks collapse. This is the kind of one-off news that appeared in the red days of March 2020 to indicate good places to buy.
Such a capitulation seems a long way off for the time being. According to statistics from Nordnet, Finland's largest blue-chip broker, its customers are enjoying better leverage than ever before. In other words, people are buying the dip with borrowed money. In general, people have been buying up shares in a frenzy. If the general fall in share prices continues, we will next see stories of forced sales…
However, in the dips of recent years, Finns have bought loads of shares from the dips, and have often been right. There is no point in trying to swim against the people. This was the case, for example, in the panic collapse of the COVID pandemic.
In the US, the world's largest stock market, the use of investment debt has turned upwards in dollar terms, but relative to the value of the stock market as a whole, the use of investment debt is the lowest in 20 years.
Heavy debt repayments have often indicated stock market bottoms and so far those bottoms were still found in the US last fall at a time when the debt contraction was at its peak. Now we are back to normal.
Yet another recession alert
Since interest rates started to rise in fall 2021, investors have been getting their hopes up for tightening monetary conditions leading to a recession. So far, instead of a recession, we have witnessed red-hot economic figures, especially in the United States. Economies that have slipped into recession, or close to it, are those of less importance to the global economy, such as Sweden, Finland, or Germany.
Despite the sigh of relief so far, the recession alarm is sounding once again.
It often takes a while for the moving parts of the economy to make a real impact. For example, the war in Ukraine and the energy crisis did not hit Nasdaq Helsinki results as hard as initially feared. At max, in specific sectors, such as discount retail. By contrast, the broadly weak performance of Finnish companies is now evident. Investors tend to overreact at first, and then forget about the bad news until it has built up enough momentum to surprise them again.
The global economy can withstand recessions in all other countries, but if we conclude that private consumption is ultimately the engine of economic activity, the US is the locomotive of the global economy. If households do not spend, businesses will not recruit and invest. Caricaturedly, the way the world economy works is that Americans consume more than they produce, which provides an opportunity for the rest of the world economy to produce more than they consume. If the American consumer coughs up, Chinese and German producers get the flu. And since China and Germany are important markets for Finnish listed companies, the domestic stock market gets infected too.
The inversion of the yield curve, i.e., the downward shift in the relationship between long and short rates, has been a reliable - yet temporally imprecise - recession alarm for the past few decades in the United States. Specifically, over the past 50-plus years, every time the yield curve has dipped into negative territory and then come back the right way, a recession follows with a lag of a year or two. The yield curve turned negative in the summer of 2022 and was then forgotten by investors, but in recent days, not caring about the bends, it has turned towards the surface. It hasn’t turned positive yet, but at the current rate of increase in long-term interest rates, that won't take long.
However, this time is different from the last couple of times. This graph shows the US 2-year and 10-year bond rates. Before the 2020 recession, the financial crisis, the tech bubble recession, and the recession of the early 1990s in the US, shorter rates started to collapse faster than longer rates, sniffing the Fed's rate cuts. Instead, this time both long and short rates are still rising, as if in anticipation of a stronger economy and inflation, and long rates are outpacing short rates from below.
The last time this happened was in the mid-1980s, during the last energy and inflation crisis. In this respect, the situation is different, and the severity of the recession signal is still a question mark.
The interest rate market is not the only one ringing the recession bell. The leading economic indicator compiled by the Conference Board think-tank has been shouting red for more than a year now, while economic growth in the US has in fact only accelerated.
The indicator is weighed down by factors such as financial conditions and new industrial orders but is buoyed by building permits and positive wage developments.
I don't know the US construction market very well, but despite mortgage rates hovering around 8%, the number of building permits has started to increase after a slight respite. In almost every recession, construction has fallen by the wayside, and that doesn't seem to be happening now.
This graph shows private residential construction and other construction, such as industrial construction, in the United States. During last year's mini housing boom, other construction reached record levels. Again, one may wonder what these statistics can improve in the future, given the mature phase of the economic cycle and the high interest rate level. However, construction accounts for around 4% of GDP in the US, so there is no point in over-dramatizing these curves.
Against the backdrop of these ill-timed recession alerts flew last Friday's strong employment data. According to preliminary data, more than 300,000 new jobs were created in September, while the August figures were revised upwards. The unemployment rate remained unchanged at 3.8%. Despite the strong momentum in the labor market, wage growth slowed to just over 4%, although this is still a high level. The market initially reacted to the figures with horror, but ultimately a positive interpretation triumphed, with job growth pointing to a strong economy and cooling wage growth pointing to cooling inflation. However, a strong labor market does not give the Fed any reason to lower policy rates. Before the pandemic-era labor market shocks, wages were growing at an annual rate of around 3% and there’s still some way to go to that level. If more pairs of hands return to the workforce from the pandemic-era sabbaticals, a strong labor market could feed the economy for a long time to come. It should also be noted that labor market figures are often corrected ex-post and the labor market is otherwise a lagging indicator. New jobs can still be created at the very threshold of the recession.
All in all, the world's most anticipated recession is still a long time coming, although the warning signs of its approach are getting stronger despite the strong data so far.
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