This is one of those strange times when markets appear to be sending conflicting signals. Specifically, the 15 per cent rebound in the S&P 500 stock index since bottoming in mid-June suggests a light at the end of the economic tunnel.

In fact, second-quarter corporate earnings came in better than feared and last month’s jobs reports showed that employment remains strong by some measures.

And yet, other economic data point to a slowdown. The US reported an inflation-adjusted gross domestic product decline of 0.9 per cent in Q2 following a drop of 1.6 per cent in Q1. Two consecutive quarters of negative GDP growth already meets some analysts’ definition of a recession.

Leading economic indicators also suggest further softness. America’s ISM purchasing manager indices for manufacturing and services have fallen 17 per cent and 33 per cent, respectively, over the past year. While the US manufacturing PMI stands at 52.8, the latest reading on the services PMI showed a decline to 47.3.

Numbers below 50 in this data series indicate a recession.

Higher interest rates are starting to impact consumers. Last month, we saw housing starts drop by 13 per cent, as new home sales fell to the lowest level in two years. Automobile sales are down about 12 per cent over the past year.

In the fixed-income markets, longer-term bond yields have declined by 65 basis points (0.65 per cent) since mid-June while short-term interest rates pushed higher, thus making the US government yield curve inverted. The two-year treasury now yields about 0.34 per cent more than the ten-year bond. Market followers may know that this atypical pattern often predicts an impending recession.

With equities suggesting better times ahead and bond markets predicting a recession, which one is right?

The answer to this question lies in how far governments will go to push their monetary and fiscal agendas.

So far this year, the Fed has been raising interest rates rapidly in an effort to cool sky-high inflation by slowing growth. In classic form, America’s central bank has been acting like an arsonist firefighter attempting to extinguish the inflationary fire caused by its own excessive money printing combined with government overspending during the worst years of the pandemic.

Raising the funds rate makes borrowing less attractive as it is tied to most other interest rates including home mortgages, adjustable-rate loans, credit card debt and consumer loans. Furthermore, tighter credit market conditions slow business expansion plans when their cost of capital increases.

As we have seen this year, rising interest rates can also make the investing environment more challenging. Slower growth and competition with higher bond yields reduce the price-earnings multiple and therefore the price investors are willing to pay for stocks. At the same time, bonds are directly impacted by rising interest rates as existing bond issues with lower coupons are priced at lower market values. On the plus side, higher rates mean maturities can be invested at better yields.

Notwithstanding the recent bounce, individual equity market sectors have performed as one would expect before and during a recession. Defensive sectors including healthcare, consumer staples and electric utilities sectors have significantly outperformed the market year to date, while more economically sensitive sectors such as financials, industrial and consumer discretionary have lagged. Energy has thrived this year mainly due to supply-side constraints and the war in Ukraine.

The level of credit spreads in the bond market represents another barometer of economic health. The yield differential between a credit risk-free ten-year government bond and an average BBB-rated corporate bond have risen more than 60 per cent since the beginning of the year. This indicates that investors are concerned about credit defaults, which would likely become more problematic in a recession. Rising credit spreads mean that investors now require higher returns on riskier securities.

This economic cycle, like others in this millennium, will ultimately be determined by government. The arsonist firefighters in Washington have caused, or at least exacerbated, all past business cycles in recent history and this one should be no different.

In a normal environment, higher prices are corrected by the higher prices themselves. For example, if consumers must pay more for goods and services, they will simply buy less or find lower-cost substitutes, which ultimately brings prices back down.

However, today’s economy features government with its hands on everything. America’s Inflation Reduction Act (which actually will not reduce inflation, according to experts) is a prime example of how scarce resources are being diverted away from the private sector towards government.

Investors should be prepared for more interventions in form of further interest-rate increases, quantitative tightening, increased regulations, price controls and other fiscal and monetary policies which interrupt the normal flow of business.

In the meantime, markets appear to be calling the Fed’s hawkish bluff. America, like many other so-called developed countries, continues to spend beyond its means without regard to deficits.

Now owing a record $30 trillion in debt, and at 137 per cent the largest debt/GDP in the history of the country, each 1 per cent increase in the US interest rate translates into an additional $300 billion in debt servicing. That’s a serious problem for both the short and long run. The government has less flexibility than they would like us to believe.

In the months ahead, expect backward-looking data points such as employment and headline inflation to begin drifting lower. In this environment, equity investors should stay well diversified while leaning into quality. Bond investors are still better off with maturities inside of five years, thereby benefiting from the most attractive part of the yield curve.

Bryan Dooley, CFA is the Chief Investment Officer at LOM Asset Management Limited in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.