On the Road to Recession?

Written by Rory Hickman

Chris Watling, founder, CEO, and Chief Market Strategist of Longview Economics, has a stark warning for the real estate industry - a recession is approaching. Watling sat down with GRI Club ahead of his upcoming keynote address at Europe GRI 2023 to discuss how we arrived at this point and shared his expert insights on how the situation could play out.

Since 2003, rooted in a profound interest in global macroeconomics, Watling's company has grown into a robust team of experts with a global clientele spanning Europe, Australasia, and North America. 

Now commemorating their 20th anniversary, Watling and his team engage in multifaceted conversations with investors encompassing a wide spectrum of financial matters and asset classes. Their discussions traverse equities, bonds, currencies, commodities, volatility, credit, and more. 

In this complex web of financial interactions, real estate emerges as a pivotal component, serving as one of the key cornerstones in the puzzle of global asset allocation and playing an indispensable role in driving the global economy.

Manipulating Metrics

Talking with GRI Club, Watling shares that he prefers not to be constrained by any one economic theory, instead pointing out that they can all have merit - each being applicable at different times. The challenge, he says, is understanding which theory applies to the current state of affairs.

As an example of this, the recent resurgence of high inflation has prompted renewed interest in monetarism, which was a fashionable theory in the 60s and 70s after Milton Friedman’s milestone publication of ‘A Monetary History of the United States, 1867–1960’ in 1963.

The theory initially gained traction with the targeting of money supply metrics in the 1980s by many Western governments and policy makers. However, it fell down as money supply growth started behaving erratically, reflecting the unwelcome embrace of ‘Goodhart's Law’ - "when a measure becomes a target, it ceases to be a good measure." It then had two challenging decades - largely falling out of favour by the end of the 90s.  

The irregular behaviour of the money supply metrics primarily started in the 1980s, as the financial sector deregulated, initially under Thatcher and Reagan, and then later under BASEL I, II & III. In particular, as the sector underwent this deregulation, the nature of money creation within both commercial banks and the wider financial sector changed, and with that so did the behaviour of money supply metrics relative to inflation and the economy. Hence the theory falling out of favour. 

Since the start of the pandemic, though, the tight relationship between money growth and consumer price inflation has re-established itself, reflecting the nature (i.e. ‘helicopter money’ policy) of the policy makers’ response during the pandemic. As such, monetarism, as a theory, is once again in the ascendency with respect to understanding and forecasting today’s economy. 

New vs Old Normal

In the aftermath of the 2008 Global Financial Crisis (GFC), the world grappled with what was heralded as the "new normal" by many economists. That environment was a stark departure from the preceding decades of the "Great Moderation" from the late 80s through to the early 2000s, an era that had been characterised by low financial volatility and inflation that remained well in check.

The “new normal” was a phrase, coined by US asset manager Pimco in 2009, to describe “a period of time in which economies grow very slowly as opposed to growing like weeds…; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), starts saving to the grave.”(1)

Longview's perspective deviated somewhat from that narrative and challenged the idea that it was a "new normal” - instead positing that it was actually a return to the "old normal" - one that bore many of the hallmarks of the 1930s. This was a prior time of banking crises and a deflationary impulse as the banking sector shrank or consolidated, money supply contracted, animal spirits were suppressed, and deflationary forces undermined the foundations of the global economy. 

To counteract deflation, the modern approach of quantitative easing (re)emerged, with central banks printing money to stave off the looming recession and deflationary impulse.

According to Watling, the period following the banking crisis of 2008 until around 2017 is more aptly labelled the "post-banking deflation healing phase," or simply ‘the Old Normal’. Rates plummeted, bonds yielded minimal returns, and central banks embarked on a journey of printing money to buoy economies. This, in turn, offered support to stock markets that were grappling with the aftershocks of the financial turmoil.

Not If But When

Watling also shared his assessment that the global economy now stands poised on the edge of an impending recession. The only question that seems to hang in the air is not "if," but "when," with speculation ranging from the latter half of 2023 to the early months of 2024.

Key indications of this impending economic slowdown are already discernible in various sectors. Tightening measures are taking hold, as seen with stricter lending practices from banks, a damaged mid-sized banking sector in the US, and restricted access to financing across various industries. The previously smooth and accessible financial environment now appears constrained and cautious.

The challenge in forecasting the timing of the recession stems from the ways in which macroeconomic dynamics were impacted by the significant disruption brought about by the pandemic. Many individuals saved significant amounts of money in the pandemic, for example, and have lived off those savings for the past 1-2 years. 

Other distortions included the notable increase in second-hand car prices and other service sector prices, which subsequently influenced inflation rates and therefore monetary policy, to a degree.

Banking on Bonds

In the wake of these unprecedented disruptions, a crucial debate is now playing out in markets and amongst economists about the possibility of a wage-price spiral. Understanding how that risk evolves is critical for discerning trends in global markets. 

In particular, Watling notes that a clear assessment of the broad drivers of inflation, including the wage price spiral issue, is essential in order to undertake a rational appraisal of bonds, in particular UK GILTS and US treasuries - which act as anchors in most investment portfolios. The growth outlook is also critical. 

Getting those key questions right will determine how to invest in bonds, i.e. whether over or underweight. 

Of late, US 10-year bond yields have gotten back to their October 2022 peak yield (4.25%), with the market pushing through that record level to close with a higher yield in mid-August. 'Where to go now?’ is therefore a critical question for investment portfolio decision makers.

If bonds rally in price (yields fall), then their attractiveness is not only limited to the promise of future yields, says Watling, but also extends to potential capital appreciation. As such, holding these bonds would generate an attractive return, notably in excess of the 4% coupon yield.

Examining Equity

Strategies become more nuanced, though, when it comes to equity markets. Country and regional factors, preferred investment styles, and appetite for risk are amongst many other factors that all have a part to play. A global stock market rife with valuation gaps presents many opportunities. 

The allure of embracing cutting-edge technologies, particularly the growing influence of AI, can be a driving force in investment choices, as investors fear missing out on “the next big thing.”

The tech sector is notably overvalued, however. It is in fact at its most pronounced level, in comparison to the global market, since the tempestuous era of the TMT bubble in the 1990s. As investors navigate this complex situation, extreme valuation differentials offer avenues for potential profit - particularly for investors with long timeframes.

Those extremes manifest across a multitude of sectors and geographies, including pairs such as the US tech versus the UK stock market, for example. Watling notes that the energy sector - and the market in general - is cheap and often overlooked in the UK, despite relatively low valuations.

With the promise of interest rate reductions on the horizon, lending is poised to increase (Image: RossHelen | envato)

Deployment Dynamics

Longview's understanding that investment patterns are far from static leads them to foresee a resurgence of value-oriented strategies and expects Non-US equities to take a leading role in the market over the next 3-5 years.

With the promise of interest rate reductions on the horizon in the coming 12 months, lending is poised to increase as banks express a renewed appetite for deploying capital. The effects of reinvigorated lending activity will have a profound impact on the real estate market going forward.

To benefit further from Chris Watling’s incisive analysis of the current scenario, as well as the opportunity for insights and networking with more than 600 top industry experts, don’t forget to register for Europe GRI 2023. The continent’s premier real estate event will be held on September 12-13 in Paris, France.

Sources:
1) Bill Gross, Pimco, September 2009 - On the Course to a New Normal | PIMCO