Recession and Reversion to the Mean

As we approach the end of the year, economic indicators and financial metrics continue to capture the attention of investors and analysts alike. The inversion of the yield curve over the past year, alongside persistently low Purchasing Managers’ Indexes (PMIs) and other leading indicators, has fueled expectations of an imminent recession. Despite these signals, the anticipated economic downturn has yet to materialize. This prompts an examination of the reasons behind the delay and the implications for global markets.

Understanding the Current Economic Landscape

The inversion of the yield curve, a traditional harbinger of recession, has been a prominent feature of the financial landscape. Typically, this inversion occurs when short-term interest rates exceed long-term rates, reflecting investor concerns about future economic growth. Complementing this are PMIs, which have remained below the critical threshold of 50 for ten consecutive months, indicating contraction in the manufacturing and services sectors. These indicators, combined with other red flags, suggest that a recession might be imminent.

However, the expected recession has not yet arrived. One possible explanation for this discrepancy is the length of time required for higher interest rates to fully impact the economy. Historically, tight monetary policies take time to work their way through economic systems. The current high-rate environment follows a prolonged period of low interest rates, which allowed consumers and businesses to accrue significant debt and pull forward demand. This backlog of demand, coupled with the delayed effects of higher rates, may be contributing to the lag in economic slowdowns.

The Alchemy of Low Rates

The era of low interest rates fostered an environment where borrowing was inexpensive, leading to a surge in consumer spending and corporate investment. This period saw consumers locking in long-term, low-rate mortgages and corporations extending their debt at favorable terms. As rates rise, the cost of servicing this debt increases, and the impact is beginning to manifest. High mortgage rates have made home ownership less affordable, with home affordability reaching a 40-year low. Similarly, the cost of purchasing new cars has surged by 30 to 40 percent, leading to a slowdown in auto sales.

These effects are indicative of how higher rates take time to exert their full impact on the economy. The adjustments in consumer behavior and corporate strategies are gradual, contributing to the delay in observing a pronounced recessionary environment.

International vs. Domestic Stocks: A Comparative Analysis

Turning to the equity markets, international stocks have underperformed their U.S. counterparts this year, despite showing resilience during the 2022 selloff. Historically, valuations outside the U.S. have appeared attractive, yet the performance gap persists. One significant factor is the disparity in the composition of international and domestic indices. U.S. markets, particularly through large-cap technology stocks, have experienced substantial multiple expansions. These mega-cap companies, often driving innovations in areas like artificial intelligence, have significantly outperformed their international peers.

When evaluating broader indices, such as the equal-weighted S&P 500, which minimizes the influence of large-cap stocks, earnings growth has been relatively similar between U.S. and European companies. However, European stocks have shown a more modest return compared to their U.S. counterparts. This discrepancy highlights an opportunity: despite similar earnings growth, European and other international stocks have lagged due to less dramatic multiple expansions.

Currency Valuations and International Diversification

Currency valuation adds another layer to the international investment narrative. Currencies, while challenging to predict in the short term, tend to revert to their mean levels over the long term. Currently, several major currencies are undervalued compared to the U.S. dollar. For instance, the Japanese Yen is approximately 40 percent undervalued, and the Euro is about 25 percent undervalued. Similarly, emerging market currencies like the Brazilian Real and the Chinese Renminbi are also undervalued.

This undervaluation suggests that the dollar is relatively strong, creating potential opportunities for international diversification. As currencies tend to mean revert, the current strength of the dollar may not be sustainable in the long term. Investing in international equities could offer attractive returns, especially when accounting for potential currency appreciation and competitive valuations.

Conclusion

In summary, while the anticipated recession has not yet materialized, the economic signals continue to point toward a potential downturn in the future. The delayed impact of higher interest rates and the gradual adjustments in consumer and corporate behaviors contribute to the current economic landscape. Meanwhile, the international equity market presents compelling opportunities, particularly given the valuation disparities and potential for currency mean reversion. As always, investors should remain vigilant and consider both domestic and international factors in their strategic planning.