It seems that both the equity and bond markets are starting to price in a recession in the US. The bond market is discounting a rate cut of 75-100 basis points by the Fed, and the latest sell-off in equities clearly reflects recessionary fears.
It is a close call, and at this point it is simply impossible to say with a high degree of certainty whether we are already in recession or to what extent we are about to enter one. Take the recent jump in the unemployment rate for example. The 0.6% increase in this rate from its trough is larger than what we have seen in previous mid-cycle slowdowns. But it is still notably below what we have seen in past recessions. Factory orders are still rising and are significantly above the levels that are consistent with a recessionary period.
So the short answer is that nobody really knows at this point. But the more important issue is—does it really matter? After all, is there a big difference between two negative quarters in GDP growth of say a cumulative 0.2% decline, or a two consecutive quarters of a cumulative increase in GDP of 0.2%? Both are extremely weak, but the first scenario is a recession and the other is not.
What we do know is that for the US economy, the next six months will be very weak. It is also reasonable to assume that Canada will weaken significantly, but it probably will outpace the US due to a stronger real estate market and the likelihood that commodity prices will surprise on the upside.
And that is an important issue. If the fundamentals of the Canadian economy are much better, how come financial markets behave like Canada is in the middle of the American storm? Take the Real Estate Investment (REITs) sector for example. Since mid-2007, Canadian REIT prices fell by almost 25% (and by close to 30% since reaching their peak in early February). That is 10%-points more than the drop in the financial index and three times the drop in the TSX as a whole (Chart). Note the high correlation between the Canadian and American indexes, with Canadian REITs outperforming American REITs by only 4%-points during that period. That’s not much if you consider that the actual housing meltdown is happening south of the border—not here.
What’s more, when evaluated in relation to the net value of their assets, Canadian REITs are now trading at an unprecedented discount of almost 20%. That is three points deeper than the discount observed during the near-recessionary conditions of 2001.
So it is possible that we are in a midst of an overshooting—with the bond market rallying too much, and equity market correcting too deeply. Currently the momentum is negative, so fighting it is unadvisable. But when the fog clears (and it could be earlier than many people expect) look for those sectors that are now being punished (such as financials and REITs) to lead the upswing in the market.
