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Financial Conditions Warn of Rising

Recession Risk
Gabriel Agostini Gina Martin Adams
Team: Economics Team: Strategy
BI Senior Associate Economist BI Director of Equity Strategy, Chief Equity Strategist

Financial Conditions' Fast Squeeze Signals More Economic Pain

(Bloomberg Intelligence) -- Financial conditions are tightening faster and harder than in the last
hiking cycle, as demonstrated by our proprietary index, and the Fed's decision to stay the course
raises the risk of a deeper, longer recession. Historical correlations between the index and the S&P
suggest that financials, consumer-discretionary and real estate stocks are most likely to
underperform in this environment. (08/04/22)

1. Financial Tightening Far Outpaces Previous Cycle

Financial tightening has been swift, which should help dampen inflation but challenge the Fed's ability
to calibrate between too much and too little monetary restraint. The Bloomberg Financial Conditions
Index (BFCIUS), which incorporates signals from money, bond and equity markets, has fallen two
standard deviations from its record high last November, about twice the magnitude of its move in the
two years between the QE3 taper and December 2015 liftoff.

The BFCIUS' negative print, rising jobless claims and declining economic momentum all suggest that
the Fed’s impact is being felt across the slowing US economy. Even if rising recession risk nudges the
Fed into moderating its stance, we think much of the financial tightening has yet to transmit through
the economy, and more pockets of weakness are likely to arise. (08/04/22)

Financial Tightening: Then vs. Now

Source: Bloomberg Intelligence

2. Tightening at Current Clip to Increase Recession Severity

Further tightening at this pace and magnitude, particularly in the credit markets, risks inducing a
sharper economic contraction than Fed officials may deem desirable. We calculate that equity- and
bond-market tightening accounts for about 75% of the BFCIUS' retreat since July 2021, the result of a
broad-based widening of credit spreads, declining valuations and rising equity-market volatility.
Importantly, the index is now firmly in negative territory, indicating that financial conditions have
turned notably restrictive relative to historical trends.

The BFCIUS indicates that financial conditions were 0.8 standard deviations tighter than historical
norms in mid-July, a sharp turnaround from positive 1.3 standard deviations in June 2021 -- the
easiest they had been since the global financial crisis. (08/04/22)

This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and
distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India,
Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global
marketing and operational support and service for the Services and distributes the Services either directly or through a non-BFLP
subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice, and nothing herein shall constitute an offer
of financial instruments by BFLP, BLP or their affiliates.

Bloomberg® 08/04/2022 14:03:32

 This document is being provided for the exclusive use of GABRIELA MOREIRA at LAFISE VALORES PUESTO DE BOLSA, S.A.. Not for
redistribution.

Financial Conditions Take Rapidly Restrictive Turn

Source: Bloomberg Intelligence

3. Conditions Foreshadow More Joblessness

The synchronous rise in the Fed's policy rate and initial jobless claims contrasts starkly with previous
hiking cycles, the last four of which didn't see unemployment claims rise until at least a year after
rate increases began. The Fed's decision to hike, rather than pause or ease, in the midst of a cooling
labor market, risks magnifying the likelihood, depth and duration of a recession.

For now, despite pockets of weakness in the fintech, real estate and auto sectors, the level of jobless
claims remains consistent with a cooling -- not a recessionary -- job market. Weekly initial jobless
claims averaged about 308,000 and 321,000 in the year that preceded the 2001 and 2008
recessions, respectively, about 20% higher than their 256,000 average over the past four weeks.
(08/04/22)

Fed's Impact on Labor Market Almost Immediate

Source: Federal Reserve, BLS, Bloomberg Intelligence

4. Financial Conditions Point to Rapidly Rising Recession Risk

The tightening of financial conditions through the July Fed meeting implies a sharp slowing of nominal
GDP growth in 2022. Financial conditions are typically too volatile to yield a meaningful growth signal
in the short run, but they are an important determining factor over the medium to longer term. From
2013, BFCIUS leads the broad nominal GDP trend (a four-quarter moving average) by two quarters,
with roughly a 75% correlation.

The deceleration predicted by the tightening in BFCIUS would slow the nominal GDP gain sharply
toward 1% by year-end, a level that suggests implies negative real GDP growth and recession. This is
a sharper slowdown than the implied nominal growth trend derived from Bloomberg consensus,
which is closer to 6% (extrapolating from projections for real GDP and headline inflation). (08/04/22)

This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and
distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India,
Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global
marketing and operational support and service for the Services and distributes the Services either directly or through a non-BFLP
subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice, and nothing herein shall constitute an offer
of financial instruments by BFLP, BLP or their affiliates.

Bloomberg® 08/04/2022 14:03:32

 This document is being provided for the exclusive use of GABRIELA MOREIRA at LAFISE VALORES PUESTO DE BOLSA, S.A.. Not for
redistribution.

Financial Conditions Tightening, GDP Weakening

Source: Bloomberg Intelligence

5. Procyclical Sectors at Mercy of Financial Conditions

Procyclical sectors tend to be the most vulnerable to tightening financial conditions, our analysis
shows. The BFCIUS is closely correlated (60-70%) with S&P 500 returns for the financial, consumer
discretionary and industrial sectors since 2000. Conversely, defensive sectors like utilities and
consumer staples tend to be less sensitive to financial conditions.

If conditions turn restrictive too rapidly, we would expect to see the first signs of operating-margin
pressure in cyclical sectors, some of which have sold off more sharply year-to-date. Interestingly, the
positive correlation between financial-sector returns and financial conditions suggest that, in
previous cycles, higher interest margins have been unable to offset the margin pressures posed by
tighter financial conditions’ impact on the economy. (08/04/22)

Cyclical Sectors Vulnerable to Tighter Conditions

Source: Bloomberg Intelligence

To contact the analyst for this research:

Gabriel Agostini at gagostini11@bloomberg.net

This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and
distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India,
Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global
marketing and operational support and service for the Services and distributes the Services either directly or through a non-BFLP
subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice, and nothing herein shall constitute an offer
of financial instruments by BFLP, BLP or their affiliates.

Bloomberg® 08/04/2022 14:03:32