Current Macro Environment

Inflation remains a central concern for both individuals and the broader market. The blue line in the depicted chart represents the total Consumer Price Index (CPI), and the green line signifies the core CPI. Both indices have witnessed varying declines from their peaks last year.

The total CPI has currently receded to approximately 3%, while the core CPI demonstrates greater resilience. The core CPI, unlike the total CPI, excludes categories such as energy and food, known for their larger price swings. Consequently, the core CPI is less volatile but tends to be more stubborn in its movement. The decline in oil prices over the past year has significantly impacted the total CPI. However, the market’s main focus currently lies with the core CPI as it better encapsulates inflation levels, given it includes the prices of rent, services, and daily necessities.

Figure 1: US CPI and Core CPI Trends 

Source： FactSet, US Tiger Securities Research 

In response to inflation, the Federal Reserve has implemented a significant rate hike of 500+ basis points in the current cycle. The Fed pursues two key objectives: controlling inflation at a target of 2%, and maintaining a low unemployment rate. The recent rate hike is remarkable for its magnitude—being the most substantial in recent decades—and its speed, with a 500+ basis-point hike achieved within approximately 18 months. 

Yet, despite these aggressive monetary adjustments, the U.S. economy has remained resilient, and has not entered the anticipated recession. Generally, an economy is deemed to be in recession if GDP contracts for two consecutive quarters. However, exceptions can occur, as seen during the pandemic period. Currently, the U.S. economy has exhibited a 1.8% growth in the recent quarter after inflation adjustment, comparable to the pre-pandemic level, suggesting that a recession has not materialized. 

Figure 2: US Fed Fund Rate 

Source： FactSet, US Tiger Securities Research 

Those familiar with economic trends would be aware that the inversion degree between two-year and ten-year U.S. Treasury yields often serves as a predictor for recessions. The chart depicts the U.S. Treasury bonds yield curve. The lowermost yellow line portrays the yield curve from the same period last year, whereas the upper lines reflect the recent yield curves. 

In a normally functioning economy, the yield curve typically follows the pattern of the yellow line: lower yields for short-term bonds and higher yields for long-term ones, accounting for the increased risk taken on by the holders of longer-term bonds. However, when yields of short-term bonds surpass those of long-term ones, it often signals a potential economic recession. This scenario arises as market participants consider current interest rates too high, forecasting an economic downturn that would prompt the Federal Reserve to reduce interest rates. 

Figure 3: US Treasury Yield Curves 

Source： FactSet, US Tiger Securities Research 

Another significant gauge of economic health is the unemployment rate. Currently, the rate sits at a historically low 3.5%, suggesting a robust employment market with no evident recessionary indicators. 

Figure 4: US Unemployment Rate 

Source： FactSet, US Tiger Securities Research

Why Hasn’t There a Recession Yet? 

Upon reviewing the broader macroeconomic landscape, we turn to a commonly raised question: Despite the Federal Reserve’s rate hikes reaching a decade-high in terms of scale and speed, and the pronounced inversion between the two-year and ten-year Treasury yields, why has the U.S. not yet entered a recession? 

Firstly, we’ll consider the accuracy of the two-year and ten-year yield differential in predicting recessions. In the chart, the blue line represents the differential between ten-year and two-year Treasury yields. Under normal economic conditions, this value tends to be positive, indicating no yield inversion. 

When this differential turns negative, it signals a yield inversion. The chart’s gray areas denote U.S. economic recession periods. As can be seen, nearly every inversion has led to a subsequent economic recession, attesting to the historical reliability of this indicator. Presently, the extent of yield inversion surpasses that observed prior to the 2008 financial crisis, prompting market participants to forecast a potential U.S. recession. 

Figure 5: Treasury Yields and Recessions

Source： FRED, US Tiger Securities Research

What has prevented the U.S. from entering a recession up until now? We attribute this to several factors. Primarily, the job market continues to be tight. The attached chart illustrates the U.S. labor participation rate—indicating the proportion of the population intending to work. A rise in individuals disinclined to work contributes to a declining labor participation rate. 

The chart demonstrates the steep decline in U.S. labor participation rate due to the pandemic. Despite some recovery, the current rate remains lower than the pre-pandemic levels. There are a few potential explanations for this phenomenon. One could be that individuals nearing retirement have opted for early retirement following the pandemic. Another reason might be a decrease in job-market reentry willingness among workers who lost their jobs during the pandemic. 

Conversely, the U.S. economic recovery has sustained strong demand, leading to a labor shortage across various sectors. This situation enhances workers’ wage negotiation power, fostering substantial wage growth and thereby preserving a relatively robust level of consumer spending power that has not been excessively eroded by inflation. 

Figure 6: US Labor Force Participation Rate 

Source： FRED, US Tiger Securities Research 

Figure 7 illustrates a metric representing the number of job vacancies in the U.S. labor market; a higher figure corresponds to a greater number of unfilled positions. It’s evident that the current level significantly exceeds that of the pre-pandemic period, with around 1.6 job vacancies for each unemployed individual compared to approximately 1.2 prior to the pandemic. Despite a recent decrease in the number of vacancies, the figure remains notably high, suggesting persistent tightness in the job market. Consequently, wage increases are likely to persist in the short term. 

Figure 8 illustrates the year-over-year growth in U.S. hourly wages. Notably, the present wage growth rate surpasses the average level prior to the pandemic. 

Figure 7: Total Non-Farm Job Openings (JOLTS) 

Source： FRED, US Tiger Securities Research 

Figure 8: US Hourly Wage Y/Y Growth 

Source： FRED, US Tiger Securities Research 

The second factor, in our view, relates to the U.S. government’s fiscal stimulus policy implemented during the pandemic, which led to a substantial increase in the savings of Americans. This was a result of two aspects: the government distributing money to individuals, increasing their disposable income, and the enforced lockdowns reducing everyday expenses, collectively contributing to a surge in personal savings. Many may remember that during this period, with extra money in hand and restricted consumption opportunities due to lockdowns, people turned to trading stocks and cryptocurrencies from home, fueling a bull market in U.S. equities. 

Although these surplus savings later contributed to rising inflation, they also helped many consumers mitigate the financial pressure brought about by inflation. Therefore, the Federal Reserve’s current interest rate hikes appear to have limited impact on the demand side and seem relatively ineffective. Certain studies suggest that U.S. households accumulated approximately $2.1 trillion in excess savings during the pandemic. As of May this year, roughly $1.6 trillion of this amount has been spent. Based on the current spending rate, it’s anticipated that these surplus savings will be fully depleted by the fourth quarter of this year. 

Figure 9: US Household Excessive Savings 

Source： Federal Reserve Bank of San Francisco, US Tiger Securities Research 

The final factor is the reasonably moderate level of consumer debt. The orange line in this chart depicts the scale of consumer loans, demonstrating that the proportion is not excessively high. Furthermore, we observe a substantial growth in household net assets in recent years, bolstered by the appreciation of the stock market and asset valuations. This growth fosters consumer confidence, which subsequently aids in safeguarding the U.S. economy from a potential recession. 

Figure 10: US Household Assets and Liabilities 

Source： Macrobond, US Tiger Securities Research 

The final reason, we believe, is the pandemic’s differential impact on supply and demand, leading to an asynchronous recovery across various sectors of the U.S. economy. When one area underperforms, another may be robust, thus avoiding a simultaneous slump. For instance, during the pandemic, supply chain disruptions and isolation measures led to a concurrent contraction in manufacturing and services. This chart shows the Purchase Manager’s Index (PMI) for both sectors, with the blue line representing manufacturing and the green line representing services. Both indicate a simultaneous contraction. 

However, as pandemic restrictions eased and supply chains restored, the manufacturing sector recovered earlier, peaking in the first half of 2021. Conversely, the service sector’s peak recovery didn’t occur until late 2021, a lag of nearly a year, due to continued consumer caution about potential COVID-19 exposure. 

The current scenario is that the manufacturing PMI has remained below the expansion-contraction threshold of 50 for six consecutive months, indicating contraction. Meanwhile, the service sector continues to expand. This divergence is attributed to the gradual unleashing of pent-up travel demand, while the consumer appetite for goods has reached a relatively low level. In essence, during the initial stages of pandemic recovery, although the service sector lagged, manufacturing propelled economic growth. Now, despite a slump in manufacturing, a resilient service sector averts a potential economic downturn. 

This sectoral asynchrony is also mirrored in policy and regional variations, details of which will not be covered here. 

Figure 11: US Manufacturing and Non-Manufacturing PMIs 

Source： FactSet, US Tiger Securities Research 

Is This Time Different? Will There Still Be a Recessions? 

Let’s first set aside our conclusions and examine the structural changes in the labor market. In economics, there’s a concept known as the Phillips curve, which describes the relationship between unemployment and inflation rates. Essentially, it’s intuitive: high unemployment correlates with low inflation, and vice versa, as depicted by the light blue line in the graph on the left. 

However, the slope of this curve has significantly changed post-pandemic. Looking at Figure 12, the blue dots represent pre-pandemic data points, which align closely with the trend line. The green dots represent data points during the pandemic and suggest a flatter trend line because, even though unemployment was high at the time, price levels didn’t change dramatically. However, this period was an anomaly, short-lived, and hence provides limited insight. The red dots, on the other hand, represent post-pandemic data, showing a steeper Phillips curve that has shifted upwards. This isn’t difficult to understand, as post-pandemic labor market tightness kept unemployment rates relatively low, while initial stimulative policies and supply chain issues pushed prices higher. 

Therefore, based on this post-pandemic curve, to lower inflation to the Fed’s target, a higher increase in unemployment rate than in the past would be required. However, it’s critical to note that an increase in the unemployment rate can be both a cause and effect: a deteriorating economy leads to higher unemployment, which in turn can further weaken the economy. Thus, we posit that unless the U.S. undergoes at least a mild recession, achieving the 2% inflation target may not be feasible.  

Figure 12: Phillips Curves Before, During, and After the Pandemic 

Source： https://cepr.org/voxeu/columns/inflation-covid-demand-or-supply 

Figure 13 depicts economic recessions and unemployment rates since the 1940s. It becomes apparent that each increase in the unemployment rate has been triggered by a recession. Without a recession, the unemployment rate wouldn’t increase on its own. 

Figure 13: US Unemployment Rate and Recessions 

Source： FactSet, US Tiger Securities Research 

Let’s consider the major determinants of the current inflation environment. The disinflation experienced in the aftermath of the pandemic reveals a certain misalignment across different economic sectors. The drivers of this inflation cycle can be attributed to supply-demand dynamics. Disruptions in upstream products and supply chains, due to the pandemic and the Russo-Ukrainian conflict, led to a supply contraction and consequently, price inflation. Additionally, extensive fiscal stimulus by the U.S. government amplified consumer spending power, thereby escalating demand and prices. 

The graph representing the Core Personal Consumption Expenditures (PCE) Index—another inflation benchmark akin to the CPI—offers valuable insights. This estimate, provided by the San Francisco Federal Reserve, demonstrates that green signifies supply-induced inflation, blue represents demand-driven inflation, and yellow indicates uncertain inflation. It is evident that supply-driven inflation has receded from its late 2021 and early 2022 peak, whereas demand-driven inflation persists at elevated levels. Anticipated disinflation will primarily hinge on demand moderation, which inherently is more resilient. The Federal Reserve’s interest rate hikes are fundamentally designed to suppress demand. 

Figure 14: Inflation Drivers 

Source： Federal Reserve Bank of San Francisco, US Tiger Securities Research 

Another reason we believe a recession might be inevitable is the difficulty in managing the degree and speed of interest rate hikes. Consider that past Federal Reserve chairs and representatives have all been preeminent economists or industry leaders. Despite this, almost every inflation-containment measure taken, including raising interest rates, has eventually led to a recession. The graph below illustrates this point: the blue line represents the Federal Funds Rate controlled by the Fed (the target of the interest rate hikes), and the gray areas represent recessions. Since the 1970s, out of nine interest rate hike cycles, only two have not resulted in a recession. 

We believe the primary reason for this pattern is the human element in the economy. People’s economic decisions, including buying a house, car, or consumer goods, are based on their perception of the current situation. This results in an inherent cyclicality in the economy, with periods of overheating and contraction. Rarely does the economy operate along a line of natural growth. 

Therefore, interest rate hikes are difficult to control. As it stands, the Fed has already raised interest rates by 500+ basis points, and many people still perceive the economy as performing well enough to continue consuming and investing. However, a sudden shift in perception due to a specific trigger could lead to a significant change in the economic outlook. The reflexivity of the economy is strong: when you believe the economy is doing well, you consume, borrow, and invest, which, in turn, improves the economy. However, there are always limitations to how much you can consume, borrow, and invest; once these limits are reached, the economy begins to slow down. As soon as you perceive the economy as performing poorly, you reduce consumption, borrowing, and investing, which further exacerbates the poor performance of the economy. This situation reinforces your perception, leading to further cuts in consumption, borrowing, and investment. Therefore, the expectations of economic participants can truly drive the economy in the expected direction. Once a trend is established, it’s challenging to reverse in a short time. This is another reason we believe that the U.S. may face a recession. 

Figure 15: US Fed Fund Rate and Recessions 

Source： FactSet, US Tiger Securities Research 

How to Position for a Potential Recessions? 

Hence, let’s look at how we should invest now if we are to face a recession. We should use history as our guide, and examine how the market performed during previous recessions. Although this might seem like looking for a lost sword by marking the boat (a Chinese idiom meaning taking measures irrelevant to the actual situation), it can still aid us in understanding the underlying reasons and determining whether current circumstances will follow similar patterns. 

Examining the tightening cycle before the 2008 financial crisis provides insightful perspectives. In Figure 16, the S&P 500 index (green line, left chart), representing the stock market, exhibited robust performance during the tightening process. Simultaneously, bond markets, illustrated by the 10-year Treasury yield (green line, right chart), remained in a state of flux without a discernible trend. Post-tightening, and before the onset of monetary easing, the equity market maintained its bullish run, whereas the bond market continued its oscillatory behavior. With the initiation of the easing phase, the equity market faced a precipitous drop, conversely leading to an ascent in bond prices. 

Figure 16: Stock and Bond Performance During the Tightening Cycle before 2008  

Source： FactSet, US Tiger Securities Research 

We now turn our attention to the 2015-2020 tightening cycle. This period is distinctive due to the 2020 recession triggered by the pandemic, casting doubt on whether the recession would have occurred without COVID-19, and whether it can be directly attributed to monetary tightening. However, the Fed had initiated easing even before the pandemic, allowing this period to be studied as a tightening cycle. 

As observed, during the tightening phase, equities continued to rally while bonds declined. In the period between the end of tightening and the start of easing, both equities and bonds appreciated. Following the initiation of easing, equities did not immediately fall. However, during the pandemic-induced recession, the equity market plummeted while bonds continued to appreciate. The narrative quickly reversed following a swift response to the pandemic from the U.S., with the rapid introduction of numerous stimulus policies leading to a speedy end to the recession. 

Figure 17: Stock and Bond Performance During the 2015 – 2020 Tightening Cycle  

Source： FactSet, US Tiger Securities Research 

Lastly, let’s examine the cycle preceding the dot-com bubble in the year 2000. During the tightening phase, equities appreciated while bonds declined. When interest rates were at their peak, equities continued their upward trend, whereas bonds fluctuated. With the initiation of the easing cycle, equities started to decline, and bonds appreciated. 

Figure 18: Stock and Bond Performance During the 1993 – 2000 Tightening Cycle  

Source： FactSet, US Tiger Securities Research 

Consistent patterns can be observed across different interest rate hike cycles: 

1. During the rate hike phase, equities invariably experience a rise, while bonds predominantly decline, or at best, remain range-bond. 

2. Between the cessation of rate hikes and onset of rate cuts, equities consistently continue to appreciate, while bonds primarily fluctuate, with occasional uptrends. 

3. When rate cuts commence, equities consistently depreciate, and bonds uniformly appreciate. 

These observations, although drawn from a limited number of instances, can still guide us in understanding current market dynamics. The Federal Reserve implements rate hikes in response to indications of an overheating economy. Owing to the reflexivity in economics, it’s challenging to reverse a trend in the short term once it has taken root. Thus, even at the onset of rate hikes, the economy is likely to continue strengthening for a while. Specifically, during rate hikes, robust economic data and impressive corporate earnings reports often underpin a bullish stock market and perpetuate optimistic sentiments. 

When the interest rate hikes reach a certain point, their impact on the economy begins to manifest, reflected in weakening economic indicators and corporate earnings reports. The Federal Reserve then pauses further hikes, potentially initiating rate cuts. However, due to the delay in the economic cycle, the economy doesn’t change course immediately. The continuous weakening of economic data and corporate earnings can prompt a downturn in the stock market. 

Readers might question why the latest round of interest rate hikes diverges from the usual pattern, particularly the decline in the stock market during last year’s rate hikes. 

Two primary factors could account for this deviation. First, the stock market experienced an extraordinary rally during the pandemic, leading to potential overvaluation. Such a substantial rally typically puts investors on high alert, making the market more susceptible to downturns triggered by minor disturbances. Reflecting on previous rate hike cycles, we find that significant market rallies did not precede the rate hikes. As such, the recent anomaly does not necessarily represent a failure of the stock market to rise during rate hikes. Instead, it may suggest an early rally during the pandemic, further highlighting a displacement in the current recovery phase. 

Secondly, the Federal Reserve’s recent rate hikes have been unusually rapid and steep, causing market participants to fear an imminent economic recession, resulting in a stock market downturn during the rate hike period. 

Interestingly, the expected recession did not occur last year or even thus far this year. This reality underpins the stock market’s robust performance this year. The decline last year provided room for market recovery, and the lack of a recession led investors to adjust their outlook, fueling a ‘catch up play’ this year.  

These circumstances underscore the challenges inherent in making investment decisions based on macroeconomic or corporate research. It’s often challenging to accurately capture timing and direction simultaneously, and even with precise predictions, the market may not always move as expected. Consequently, we return to a previously mentioned point: we can only prepare and should not overly rely on predictions. 

Figure 19: Stock and Bond Performance During the Current Tightening Cycle  

Source： FactSet, US Tiger Securities Research 

In conclusion, given our anticipation of a potential recession, likely to occur between Q4 this year and H1 of next year, along with the nearing end of the current rate-hike cycle, we suggest a strategic adjustment in asset allocation. Reflecting upon the 2004-2008 cycle, we may be in a phase similar to the pre-rate-hike pause, presenting potential stock market gains. However, uncertainty is high, and the risk-reward ratio for chasing this final surge might not be favorable. Thus, our strategy entails reducing stock exposure, particularly in tech stocks that demonstrated strong performance in H1. Conversely, bonds currently show potential value, and we suggest moderately increasing exposure to hedge against potential rate cuts and recession. 

For those with a lower risk tolerance, short-term government bonds offer a stable annual yield above 5%, providing a secure position for future strategic moves.  

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