What Recession?

In a year marked by widespread recession fears, JPMorgan finds the odds of an economic downturn priced into financial markets have actually fallen sharply from their 2022 highs – and last week’s better-than-expected US GDP data further backed up those odds. That may give the Fed and other central banks more ammo to carry on hiking interest rates. The European Central Bank president said just last week that investors should expect more “significant” interest-rate hikes at coming meetings. Elsewhere, Microsoft kicked off the tech sector’s reporting and gave a preview of what’s to come for the industry: falling profits. Finally, new data out last week showed that institutional investors are turning bullish on the yen for the first time since June 2021. Find out more in this week’s review.

Macro

The market-implied probabilities of a recession are tumbling according to a JPMorgan trading model. You can see that in the graph below, which shows the odds of an economic downturn that’s priced into nine different assets. The investment bank calculates these odds by comparing the assets’ pre-recession peaks to their troughs during an economic contraction. More specifically, the graph shows that the odds of a recession priced into financial markets have fallen sharply from their 2022 highs in seven of the assets.

Take, for example, European stocks, which were assigning a 93% probability back in October that a recession will hit the region. Those odds have tumbled to just 26% today. That’s not too crazy when you consider that economists at Goldman Sachs said earlier this month that they no longer see a recession hitting Europe. That comes after the bloc’s economy proved more resilient at the end of 2022, natural gas prices fell sharply, and China abandoned its Covid restrictions earlier than anticipated.

Now, the interesting thing about these market-implied odds is that they can be used to see which assets offer the best risk-reward potential to implement your specific recession views. For example, even after coming down a lot from October, you can see that the S&P 500 is still pricing in a 73% chance of a US recession – the highest out of any asset. Put differently, US stock prices are quite depressed in anticipation of an economic downturn. But that means they have a lot of upside potential if your base case is that the US will dodge a recession.

In contrast, US junk bonds (or as their proponents like to call them, “high yield” bonds) are pricing in just an 18% chance of a US recession – the lowest out of any asset. You can see why in the graph below, which shows that the yield spread between junk bonds and their Treasury equivalents is narrower than the average of the past two decades. Put differently, the additional yield that junk bonds are offering above safe government bonds to compensate for their extra risk is below their 20-year average. That means they’re not adequately pricing in the chance of a recession – and have a lot of downside potential if your base case is that the US economy will indeed enter a downturn.

Speaking of the US economy, the latest GDP report out last week came in better than expected. The world’s biggest economy grew by 2.9% on an annualized basis in the fourth quarter of 2022. That was a slight slowdown from the 3.2% registered in the third quarter, but it was better than the 2.6% economists were expecting. Consumer spending, which accounts for about 68% of GDP, increased by 2.1% during the period – down slightly from 2.3% in the previous quarter but still positive. All in all, the data provided more evidence that the US economy is proving to be more resilient than expected in the face of substantially higher borrowing costs, while also showing that the Fed’s actions are beginning to have a more noticeable effect.

Moving on, Christine Lagarde – the European Central Bank (ECB) president – had some strong words to say last Monday ahead of the central bank’s first meeting of the year this week. Lagarde said the ECB will do everything necessary to return inflation to its goal, pointing to more “significant” interest-rate hikes at coming meetings. She added that borrowing costs will have to rise at a steady pace to reach levels that are sufficiently restrictive and stay at those levels for as long as needed. See, while headline inflation in the eurozone has retreated from all-time highs, core inflation (which excludes price changes in food and energy) hit a record high last month. That’s raising concerns among some policymakers that price pressures are becoming more widespread and risk becoming entrenched in the economy.

Stocks

Microsoft’s earnings update last week was a mixed bag. The tech giant’s revenue grew by just 2% last quarter from a year ago – the weakest sales growth in six years, held back by slumping sales of PC software and laptops. That’s not a complete surprise considering that the global PC market shrank by 28.5% last quarter from a year ago according to tech research firm Gartner. Throw in a $1.2 billion charge from Microsoft’s decision to eliminate 10,000 employees, and the firm’s net income fell 12% last quarter.

But there were some positives. Revenue growth at Microsoft’s closely watched Azure cloud-computing business decelerated to 31%, sure, but that growth rate was slightly better than expected. What’s more, excluding the impact of the rising dollar, Azure’s sales rose 38%, suggesting global demand for cloud services is still holding up even as firms cut back some other corporate spending in the face of slowing economic growth. 

However, Microsoft is struggling to maintain that momentum and said that it expects Azure’s revenue growth to drop by 4 or 5 percentage points in the current quarter compared to the prior one. Hard-to-please investors didn’t like the sound of that: they sent Microsoft’s shares 1% lower after the news, erasing an earlier gain of more than 4%.

Microsoft’s update, which kicked off the tech sector’s reporting, is a preview of what’s to come for the industry. See, after seeing their valuations plummet last year, US tech stocks are about to face their next big hurdle: falling profits. In fact, according to analysts’ estimates, the fourth-quarter earnings of the S&P 500’s tech names are expected to drop by 9.2% from the year before – the steepest decline since 2016. Also notable here is how quickly sentiment has soured: just three months ago, analysts saw profits coming in flat.

FX

New data out last week showed that institutional investors are turning bullish on the yen for the first time since June 2021, amid mounting speculation that the Bank of Japan (BoJ) will be forced to abandon its ultra-easy monetary policy. That comes after the BoJ surprised markets last month by adjusting its yield-curve control program to allow 10-year bond yields to fluctuate by plus or minus 0.5%, instead of the previous 0.25%. Net asset manager positions in the Japanese currency flipped into positive territory in the week ending 17-Jan, according to the latest data from the Commodity Futures Trading Commission. Those bets come after the yen strengthened over 17% against the dollar since sliding to a three-decade low in October.

This week

Another week, another bankruptcy: crypto broker and lender Genesis filed for bankruptcy last week, ending months of wrangling with creditors. The firm’s troubles began soon after the collapse of FTX, prompting Genesis to halt customer withdrawals in November citing “unprecedented market turmoil” and liquidity issues. What’s more, Genesis parked some of its own funds with FTX. It has since been scrambling unsuccessfully to find fresh funding to pay back the more than $3 billion it owes creditors… 

• Monday: Eurozone economic sentiment (January)
• Tuesday: Japanese unemployment rate and retail sales (December), eurozone GDP (Q4). Earnings: McDonald’s, Spotify, General Motors, Exxon Mobil, Snap, Caterpillar, Pfizer, AMD
• Wednesday: US Fed decision (markets are pricing in a 25 basis point hike), eurozone unemployment rate (December). Earnings: Meta
• Thursday: Bank of England and European Central Bank decisions (markets are pricing in 50 basis point hikes for both). Earnings: Alphabet, Amazon, Apple, Qualcomm, Ford, Starbucks
• Friday: US labor market report (unemployment rate, wage growth, etc) for January