Brace for nightmare before Christmas, banking giant warns investors


Wall Street stocks and global bourses may keep climbing for a few more months before peaking in July. “Equities typically rally a little before the cycle ends,” it said.

Pinning its colours to the mast, Citigroup predicts the onset of technical recession in December, as defined by the National Bureau of Economic Research. “It won’t be exact, of course,” it said. The bank’s in-house model suggests that the likelihood of a recession over the next year has risen to a range of 37 per cent to 45 per cent. In reality, this is already within the danger zone.

We are only 15 minutes to midnight now.

Jeremy Hale and Amir Amin

Previous episodes show that once it nears 50 per cent the economy has already buckled. “We are only 15 minutes to midnight now,” said the report, by Jeremy Hale and Amir Amin.

The key trigger was last week’s inversion of the US yield curve when the market rate for 10-year bonds fell below the 3-month rate.

This tipping point amounts to a verdict by the bond markets that the Fed has entered overkill territory. It also has causal effects. The inverted curve eats into the business model of banks, which tend to “borrow short” and then to “lend long”.

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It cuts financial earnings and ultimately chokes lending. Citigroup said it was too early to abandon equities but some rotation into fixed income assets would be prudent. Wall Street typically rallies a further 11 per cent after the curve inverts, peaking four months later.

The stock market top itself anticipates the actual recession by an average of five months. But the time lapses vary.

There was almost no warning before the Great Recession. The S&P 500 index peaked in October 2007 and the US economy began to contract in November – long before the collapse of Lehman Brothers and AIG a year later.

Policy shifts can make a huge difference if they come soon enough. The Fed slashed rates by 50 points in an emergency move (unscheduled) in January 2001 and a further 50 points three weeks later but it was too late to stop recession engulfing the economy in February.

Corporate massacre

Recessions are toxic because they set off a chain reaction through financial deleveraging. Such a slump today would lead to an avalanche of “fallen angels” among US companies that have increased debt from $US2.5 trillion ($3.5 trillion) to $US6.5 trillion in nine years, mostly to buy back their own stock.

Large swathes of corporate debt rated BBB and BB are clustered precariously just above junk status. Their average net-debt/Ebitda ratio is almost six, off the charts by historical standards.

A recessionary shock would lead to a corporate massacre. This would lead to a self-feeding crisis.

It would also be a shattering blow to the eurozone, where Italy is already in recession and Germany has stalled. The European Central Bank’s key interest rate is minus 0.4 per cent.

The political bar for relaunching QE is prohibitively high. The Stability Pact prevents radical use of counter-cyclical fiscal stimulus.

A recessionary shock would lead to a corporate massacre. This would lead to a self-feeding crisis.

Christine Lagarde, the head of the International Monetary Fund, warned on Thursday that the currency bloc is “not resilient enough” to withstand another global downturn. “We need a European banking system that can bend in a storm without breaking,” she said.

Citigroup said the US Conference Board’s leading indicator has begun to turn down, a signal that should not be ignored. The short-term boost from Donald Trump’s tax cuts is fading.

The labour market is strong but it offers a rear-view mirror of the economy. Jobs gave almost no prior warning of recession in 1973, 1981, 2000, and 2007.

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One nasty catalyst could be a resurgence of US price pressures despite a slowing economy, ushering in a phase of stagflation. This would be a horrible combination for sharemarkets.

Wheels are coming off

Rival Bank of America said it expects sharemarkets to reach a “big top” in the second half of this year before investors wake up to the painful prospect of “debt deflation/policy impotence”, when the wheels come off the financial system. Its model is predicting a fall in global earnings per share of 9 per cent this year.

Bank of America’s contrarian Bull & Bear Indicator issued a general buy alert at the start of January when fear was prevalent. The Fed’s capitulation then worked its usual “Pavlovian magic on markets”, lifting commodities 14.5 per cent and global equities by 11.5 per cent over the first quarter.

The mood is turning as we enter the second quarter. Investors are switching into “deflation assets” (bonds) and the “Japanisation” trade.

We have time to prepare. But beware. Late-cycle dynamics are famously treacherous.

The Daily Telegraph, London

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