Turkey’s Path to Policy Credibility – So Far, So Good
PGIM Fixed Income shares insights on Turkey’s central bank.
The strong recovery of financial markets in recent months has far outpaced the real economy’s more mixed rebound. We show that a broadly similar divergence has been a feature of every U.S. recession for more than 50 years. Furthermore, the timing of such divergences has typically been a powerful signal of a forthcoming macro recovery.
Following an unprecedented, virus-induced decline through the spring, the U.S. economy posted a remarkably strong rebound during the summer. Third-quarter real GDP growth appears to have expanded 30% (on an annualized basis)—the strongest quarterly pace of the post-war period. Similarly, the labor market has restored well over 10 million jobs.
But, even so, the overall level of economic performance remains weak. Real GDP is down roughly 3-4% relative to its level in Q4 2019, and the labor market still has a deficit of more than 10 million jobs. Available macro indicators point to a somewhat softer pace of recovery in the months ahead, even as Washington has failed to reach an agreement on another round of fiscal stimulus—including much-needed unemployment benefits. All of this is occurring in the face of a historically contentious presidential election, with the controversies threatening to drag on until well after election day. And the virus remains a severe concern.1
Notwithstanding these uncertainties, U.S. financial markets have rebounded vigorously in recent months (Figure 1). Equity prices, while down from their early-September peak, are above pre-virus levels. Corporate spreads for U.S. investment-grade and high yield debt have also recovered substantially. While still somewhat above pre-pandemic levels, these spreads have moved back below their 20-year averages.
All of this raises the question: have the markets become unmoored from the fundamental realities of the economy?
Figure 2 draws on a recession probability model that we developed in a February 2020 white paper to shed light on this question. At the time, we found little hint of recessionary forces at work in the U.S. economy. Of course, everything changed as the virus proliferated across the globe.2
Our model assesses the probability that the economy is in recession during the coming year. Applying this framework to recent data confirms a marked divergence between the macro and financial variables.
Looking just at macro variables—including initial unemployment claims, goods consumption, and consumer confidence—the model sees conclusive evidence (100% probability) that the economy remains in recession.
In contrast, the financial model, which incorporates the Treasury term spread, real returns on the S&P 500, and the non-commercial paper spread, shows only a slightly elevated recession probability. Financial markets seem to be taking a more buoyant view of the economy’s prospects.
By our reckoning, this divergence between macro and financial performance reflects several factors. First, the Fed’s massive monetary stimulus tends to provide rapid support to the markets, but its effects on the real economy—on spending, investment, and housing—percolate more slowly over time. Second, and more fundamentally, the markets are forward-looking in their assessments. Asset prices reflect the state of the economy today, but they also factor in the prospects for economic recovery going forward.
Of course, another possibility is that large-scale economic stimulus and other policy interventions are blunting the market’s capacity to assess risks, with investors expecting further policy interventions in the event of renewed downside pressures. These expectations, in turn, may be creating unrealistic expectations for the timing and strength of the recovery, artificially lifting asset prices.
With this in mind, Figure 3 looks at the divergence between the recession probabilities obtained from the two models using data back to the mid-1960s.3 Viewed in historical context, the current divergence is significant but hardly unprecedented. Divergences of similar magnitude have occurred before. And, notably, a sizable divergence has characterized the end of all eight previous U.S. recessions.
The lower table examines these downward spikes in more detail. In each instance, the recession’s trough has been accompanied by a roughly contemporaneous divergence between the estimates of the two models. Such divergences have been remarkably reliable signals that a recession is coming to an end.
The one false positive from this framework occurred in May 2008. Following the financial disruptions in the fall of 2007 and the collapse of Bear Stearns in March 2008, it looked like stresses were poised to abate.
As just one example of perspectives at the time, at the June 2008 FOMC meeting, St. Louis Fed President Jim Bullard noted: “Policy was very aggressive during January and March of this year. This was, in part, a pre-emptive action, insurance against a particularly severe downturn brought on by financial contagion. This was a very real possibility, but it did not materialize.”
Of course, the situation deteriorated further, leading the Fed to again ramp up its stimulus. The two models again diverged in June 2009 and, this time, nailed the trough of the downturn.
These results suggest that through recessionary periods, markets have been a powerful forward-looking signal of recovery. As such, the recent rebound in financial markets, while extraordinary given the ongoing challenges the economy faces, should not be quickly dismissed as just “market exuberance.” Clearly, the macro uncertainties remain high, but in past episodes, the markets have done exceptionally well in piercing through the fog.
This material reflects the views of the authors as of October 8, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1 Consistent with these observations, the Fed’s minutes from its September meeting noted, “Participants continued to see the uncertainty surrounding the economic outlook as very elevated, with the path of the economy highly dependent on the course of the virus….”
2 Our paper, memorably entitled, “Can This Expansion Last Forever?” provides more details regarding the structure and estimation of our framework.
3Light blue shading indicates the 12 months before a recession; gray shading indicates the recession period.
All investments involve risk, including the possible loss of capital. Past performance is not a guarantee or reliable indicator of future results. Source: PGIM Fixed Income. The information represents the views and opinions of the author, is for information purposes only, and is subject to change. The information does not constitute investment advice and should not be used as the basis for an investment decision.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
Fixed income instruments are subject to credit, market, and interest rate. Emerging market investments are subject to greater volatility and price declines.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
PGIM Investments LLC is an SEC-registered investment adviser and a Prudential Financial, Inc. company. PGIM Fixed Income is a business unit of PGIM, a registered investment adviser. PGIM is a PFI company.
© 2020 Prudential Financial, Inc. (‘PFI’). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom, or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. PGIM and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
1041623-00001-00 Ed: 10/2020
Consider a fund's investment objectives, risks, charges and expenses carefully before investing. The prospectus and the summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and the summary prospectus. Read them carefully before investing.
An investment in our money market funds is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the funds seek to preserve the value of your clients investment at $1.00 per share, it is possible to lose money by investing in the funds.
Mutual fund investing involves risk. Some mutual funds have more risk than others. The investment return and principal value will fluctuate and investor's shares when sold may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. There is no guarantee a Fund's objectives will be achieved. The risks associated with each fund are explained more fully in each fund's respective prospectus. Consult with your attorney, accountant, and/or tax professional for advice concerning your particular situation.
Investment products are distributed by Prudential Investment Management Services LLC, a Prudential Financial company, member SIPC. Separately Managed Accounts are offered through our affiliates. Jennison Associates and PGIM, Inc. (PGIM) are registered investment advisors and Prudential Financial companies. QMA is the primary business name of QMA LLC, a wholly owned subsidiary of PGIM. PGIM Fixed Income and PGIM Real Estate are units of PGIM. © 2019 Prudential Financial, Inc. and its related entities. Jennison Associates, Jennison, PGIM Real Estate, PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
Investment Products: Are not insured by the FDIC or any other federal government agency, may lose value, and are not a deposit of or guaranteed by any bank or any bank affiliate.