Financial markets have experienced a bout of volatility since the start of the year. Anthony Okolie speaks with James Orlando, Director & Senior Economist, TD Bank, who tracks a number of indicators to determine whether they point to an imminent recession.
- With investors increasingly worried about a recession, James, you recently wrote a report in which you compare a number of indicators, like equity markets, for example, to historical periods of financial stress. Now before we get into the results of your report, what exactly is the financial stress index?
- Yeah, thanks, Anthony. So when we think about market movements, market stress, there's lots of different markets. There's equity markets, bond markets, currency markets. And so when we look at how this current event that we're going through right now compares to history, we don't want to just, say, look at equity markets-- and that's a great barometer-- but we want to take just a holistic view of what's going on in financial markets in general.
So to do that, to synthesize all that, we took a number of different indicators from all those markets that I mentioned and compared it into, or made it into one index, one method of measuring the amount of stress in the financial system. And so we take, for example, the equity markets, the bond markets, the currency markets, and we say, here's the level of overall stress. And it's nice to be able to synthesize it into one index and be able to compare that to different historical events.
- So what does your research indicate about the likelihood of recession when comparing today's market volatility to previous market declines?
- Yeah, that's a great question. So when you look at-- a lot of attention being made in equity markets. We got close to a bear market in the S&P 500. The NASDAQ went down more than 20%. Luckily in Canada, the TSX has fared much better. It only dropped, at a maximum, just below 5% down, so just based on the fact that we're more heavily exposed to commodities which are doing extremely well right now.
But what we did was we look back and we took a whole bunch of historical episodes going back to the Great Depression. And we broke it down into recessions, the times periods where the US economy actually fell into recession, and different equity declines where we didn't go into recession. And what we found is that recessions historically have been much more severe than what we've experienced over 2022, over the last three recessions.
So the pandemic, the global financial crisis, and the bursting of the tech bubble, we had massive equity markets declines ranging from over 30% in the pandemic to over 50% in the global financial crisis. So the almost 20% decline we saw in S&P 500 pales in comparison to what we saw then.
And what we also found is that if you look back at historical episodes-- so for example, the 2018 trade wars, you look back to the 2015 oil price shock, the sovereign debt crisis, the list goes on-- those declines are all in and around actually mostly less than 20%, but very close to what we experienced over 2022.
So what we're arguing is that the decline we saw in equity markets is probably a little bit more close to an equity market correction or recalibration of economic growth rather than calling for outright recession right now. And obviously, things can change. But given what we've seen so far, it most closely parallels these corrections that don't turn into recessions than actual recessions.
- That's a great picture, where you take a lens through the equity markets. Take us through currencies, particularly the US dollar, which has been very strong against a basket of currencies recently. It's dominated the headlines this year. What does an appreciating greenback tell us about past US recessions?
- Yeah, another excellent question. So when we think about the US dollar, generally what happens is when there's a risk off move-- so when the investors are feeling worried about the global economy-- they seek safe haven. And the US dollar historically has been that safe haven currency. So they will sell risky assets, whether it be equities, and they will buy US Treasuries. And so in buying US Treasuries, sometimes you've got to buy the US dollar. And so this happens for international investors. So seeking that safe haven is definitely what happens
We've seen the US dollar, as you correctly mentioned, appreciate. It has appreciated versus a handful of currencies, or more than handful actually, a lot of major currencies out there, the developed market peers of the United States. So for example, it's appreciated versus the Japanese yen tremendously, the British pound, the euro, these currencies have depreciated versus the US dollar. So the US dollar has been favored.
A lot of this is risk off, but a lot of it is also the fact that the US economy is looking much better than those economies. So looking better than the economies of Europe which are heavily influenced based on what's happening in commodity prices, as energy importers and so dependent on those energy prices. So as energy prices go up, the ability for those economies to withstand this energy price shock is much less than what's happening in the United States.
Japan-- they're an energy importer as well. And also, we have the Bank of Japan kind of going against the grain of central banks globally. So most central banks are looking to raise interest rates into inflation, whereas the Bank of Japan is pushing against that right now. They don't want to raise interest rates. So on a relative basis for bond markets, you're not going to be wanting to invest in the Japanese yen relative to US Treasuries because you're getting much less yield. And so all of these factors are going into currencies favoring the US dollar right now.
But one thing we've argued is that in a typical risk off event, you see much more appreciation of the US dollar than what you're seeing right now. So that's something that we're considering that the US dollar is a safe haven. It has moved, but it's not yet signaling recession in our eyes.
- And another indicator that you follow within the financial stress index are credit spreads. What trends are you seeing here, and what is that telling you about the US economy?
- Yeah, so when we refer to credit spreads, we're talking about the bond yields of major US corporations. And so when investors are not feeling very good about the economy, they're probably not feeling good about corporate profits of those corporations. And so naturally, they think they want to sell those corporate bonds. That pushes the yield up on those bonds.
And so usually when investors are really worried, they're dumping these securities hard. That pushes the yields up. And what we're seeing is that those yields are rising. But interestingly enough in the United States, the yields and the spreads relative to US Treasuries-- so we're looking at spreads here, so we're looking at what's the credit spread of a US corporation versus the yield of the US government-- and those spreads are actually below historical values when it comes to some of the investment grade bonds. They've started increasing a little bit more on the speculative grade bonds.
And so what we're showing is that, yes, people are feeling a little bit more that there's more risk in the system. They're a little bit more fearful than what they thought in, say, 2021. But these bond yields and these spreads are still well below historical values, so not pointing to imminent recession.
And even when we look over to Europe and the bonds of European corporations, we're seeing much more heightened spreads relative to the US, so relative to US corporations, but they're still not at tremendously worrying levels. They're not even at the levels of the sovereign debt crisis in Europe. So that's something that we're pointing to as well with respect to credit markets. Yes, they're tightening, but they're not tightening too much. They're not even close to what happened during the global pandemic.
- Well, I think it's fascinating how you look at all these different pieces that make up the financial stress index. Very interesting. So putting it all together, what does the index indicate about the potential of a recession, at least in the near term?
- So when we map the financial stress, financial conditions have an impact on economic growth. There's a direct linkage there and a historical trend. And so what we're showing is that the level of stress, yes, it's gone up a little bit here. But what it's showing and what it's pointing to is more of a deceleration of economic growth and not outright contraction.
And obviously, things can change. Equity markets can sell off further. But we've actually seen an improvement in risk sentiment over the last couple weeks, with equity markets bouncing off their lows, with some currencies appreciating a little bit versus the US dollar. We've seen that in Canada with the Canadian dollar appreciating over the last week.
And so what we're showing is that, yes, we're looking for a deceleration of growth, which makes sense. We have high inflation, we have higher interest rates, we have geopolitical risk. All this will weigh on economic growth. And equity markets, bond markets, and currencies are pointing to that exact same thing. But they're not pointing to the worst case outcome that you're seeing in headlines all around the world right now, which is a big global recession coming. So they're not pointing to that just yet.
- Well, James, very fascinating report. Thank you very much for bringing this to us.
- No, thank you.