- The ClearBridge Recession Risk Dashboard had no changes in January, maintaining our view that the likelihood of a recession in the next 12 months remains low.
- Credit spreads are a useful indicator due to their sensitivity and timeliness in evaluating liquidity and financial market conditions.
- A lack of movement in credit spreads gives us confidence that the current market sell-off will not lead to a bear market.
The sudden return of equity market volatility over the last two weeks has fanned fears of a bear market while heightened inflation risks also has investors worried that a hawkish Fed could trigger a recession. While it is impossible to say with certainty when the bottom of the current market sell-off will occur, we believe much of the damage from this correction has already been done.
One thing we are closely monitoring is credit spreads, which have barely budged. Credit spreads measure the difference, or spread, in yields between corporate bonds and their risk-free Treasury equivalents. As financial market risks rise, corporate bondholders demand greater compensation against the potential for insolvency. Typically, credit spreads move in tandem with equity volatility (the VIX), as both marketplaces reflect rising or falling risks. Spreads tend to widen ahead of recessions as shown by the circles in Exhibit 1.
Exhibit 1: Credit Spreads Remain Tight
While the VIX has spiked and equities have fallen over the past two weeks, credit spreads have barely moved despite the substantial rise in 10-year Treasury yields. This is one reason why we believe the current sell-off will not metastasize into a full-blown bear market as defined by a 20% or more decline in equities.
Credit spreads are one indicator we evaluate in the ClearBridge Recession Risk Dashboard due to their sensitivity, timeliness, and usefulness in evaluating liquidity and financial market conditions. Credit spreads remain solidly in expansionary territory, and 11 of our 12 indicators continue to signal all-clear (Exhibit 2).
Exhibit 2: ClearBridge Recession Risk Dashboard
As of January 31, 2018, there were no changes to the indicators in the dashboard. At the start of the year, Profit Margins was changed from Recession to Caution, reflecting a pickup in sales and potential benefits from tax reform. During January, several indicators moved higher and others lower, but none were substantial enough to warrant a change in signal from the start of the year.
Turbulent periods like the current one are the very reason we created the ClearBridge Recession Risk Dashboard. We believe this tool can help serve as a compass for equity investors, helping to show “true north” during bouts of fear and short-term market stress.