- A bear market which is in essence a valuation reset is very different (typically shorter and shallower) than a bear driven by recession;
- The US has recorded negative GDP growth led not by the consumer, but by rising inventories and falling exports;
- We are in the late phases of the market cycle and the economic cycle, but as long as the consumer is employed and spending is reasonably sustained it is hard to see an imminent recession, although that does not preclude one beginning later in the year;
- Earnings growth is slowing or likely contracting, although unevenly and with the clear exception of energy;
- The market is currently pricing 200bp or more of Fed tightening, but the rate of change of inflation appears to be falling and metrics followed by the Fed could well have turned a corner;
- Policy divergence between the US and other countries, as well as general tightening of conditions are putting a bid beneath the US Dollar, which is beginning to cause companies with dollar sensitivity to suffer;
- Assets with sensitivity to real rates, including bonds, long duration stocks, gold and silver continue to fight headwinds. Commodities have been the star performer of what increasingly seems to be a ‘stagflationary’ environment, highlighting shortages from years of underinvestment in energy infrastructure, even before Russia’s aggression;
- At some point, investors will shift focus from the Fed’s path of aggressive tightening to its endpoint. The Fed and investors will transition to considering the level at which inflation ultimately settles;
- Central banks are very much in reverse gear, and until we see new liquidity infused into markets, the bear is most likely here to stay.
RECESSION VERSUS NON-RECESSION SCENARIOS
Bear markets on average decline about 33% over 19 months, but that average breaks down into two kinds of bear. A non-recessionary driven bear market reflects valuation changes as the liquidity tide goes out and investors rein in their growth expectations for companies. This type of bear market historically has declined roughly 22% over approximately 6 months, which is within the range of what we observed in the first half of 2022. However, a more fundamental bear market due to an economic recession and significant impairment to corporate earnings goes beyond that – with declines over 35%. We are not ready to ring the bell on a recession, but we are in the advanced late phase of both the market and the economic cycle. We may be about to have an earnings contraction, which, of course, would be part of a recession scenario – in which case, markets ultimately have further to fall.
HISTORY OF U.S. BEAR & BULL MARKETS
1926 – 2019
Source: Captive International – July 2022.
ENERGY AS A SHINING LIGHT
Earnings growth is slowing or likely contracting, although unevenly and with the clear exception of energy. Consensus earnings are at 4% growth for the second quarter, however, buttressed by the momentous results delivered by energy companies – remove their contribution and earnings growth is already negative, circa minus 4%. To underline the widespread nature of the slowing earnings cycle, the breadth of companies with higher versus lower earnings estimates was 90% a year ago and is currently registering 40%.
Earnings tend to move with nominal GDP
Source: Plante Moran, PFMA, FRED, S&P Global – July 2022.
More reassuringly though, it may be that we’ve seen ‘peak’ supply chain issues and the inflationary pressures brought to bear will subside. In an attempt to avoid shortages during the pandemic, many companies double or even triple ordered inventory, to make sure they could meet a big spike in consumer demand. That said whilst we have resolved much of the shortages, there are still some products and services, including anything energy related such as truck rentals, remain scarce. So, in sum, there is an inventory overhang which has fed into disappointing economic data, but it is uneven. As global economies reopened, companies were able to raise prices in response to rising global demand. However, now faced with higher input costs, most companies are having difficulty passing on higher prices to consumers as disposable income is eroded by inflation.
MIXED SIGNALS AND CROSSWINDS
Coincident economic data is spotty – whilst the ISM manufacturing index, a widely watched gauge of economic activity has rolled over, it remains well above 50, a level below which often indicates recession. However, even in the face of woeful consumer sentiment and small business sentiment, consumer spending remains strong. Payroll data is robust, unemployment numbers, whilst lagging indicators are holding up, and TSA statistics show that people are travelling and vacationing. So, whilst it is clear that the cycle is slowing, the consumer is 70% of the economy, and as long as consumer spending persists it is hard to see an imminent recession.
ISM MANUFACTURING INDEX
PMI above 48.7 indicates overall expansion of the economy
Source: Plante Moran, PFMA, FRED, S&P Global – July 2022.
Professional fund managers generally have anticipated the equity slide of the first half of the year – and have raised significant cash. This cash could be quickly deployed sparking a rally which would not be unusual given some of the pessimism which currently envelopes stock markets. Bond markets have had one of the most torrid six month periods in history, and under normal circumstances, would have seen much stronger performance during a period of slowing growth. However, caught in the crosswinds of inflationary surprises and central banks which are well behind the curve, yields may have further to go on the upside.
ASSET ALLOCATION CONSIDERATIONS
Equities
Market leaders during this downturn have been the defensive names, particularly utilities and consumer staples. However, even bullet proof balance sheets are not completely immune – consumer staples stocks such as Colgate Palmolive, McDonalds etc are also beginning to feel the pinch from a strong US Dollar, as they have substantial foreign earnings and are therefore sensitive to currency moves.
Bonds
During the pandemic, some investors saw long duration stocks such as Apple as ‘bond proxies’, discounting a long stream of earnings. Such stocks are thus very sensitive to changes in the discount rate or cost of capital. As rates cratered, those value of those income streams were bid up sharply. However, whilst 10Y yields were approximately 1% a year ago and are now 3%, long duration names have been hit hard, as have even the ‘safest’ government bonds. A rule of thumb is that previous rate hiking cycles have ended when nominal rates move above the rate of inflation. With current year on year inflation rates registering over 8% there is clearly some way to go yet.
Precious Metals
Gold and Silver remain very sensitive to real interest rates. The change in real rates from minus 2 to plus 1 in short order has proved too much of a head wind to overcome and even geopolitical uncertainty has not been sufficient to support Gold’s advance of early 2022.
Commodities
Commodities have been the star performer in what increasingly seems to be a ‘stagflationary’ environment. Removing Russian supplies of vital commodities such as crude and fertilisers has certainly contributed to bull markets in soft commodities and fuel. Whether or not those prices hold in the face of a slowing economy, it remains the case that years of under investment in energy infrastructure had created energy shortages before Russia’s aggression.
.USD U Index (US 20 year yield) gold real yield MOnthly 30SEP1998-07SEP2022
Source: Bloomberg Finance L.P.
CONCLUSION: IT’S THE DESTINATION THAT MATTERS
Markets have had to price in a more aggressive path of central bank tightening than had been anticipated, as inflationary pressures have continued to surprise on the upside. At some point, investors will begin to focus on the final destination, the ‘terminal Fed Funds rate’, assuming that the front loading of rate hikes has been achieved to the satisfaction of the world’s central bankers.
In recent weeks, investors have lowered their expectations for the final resting place for interest rates – from 4% to 3.5%. Furthermore, the 5 year inflation rate expected in 5 years, a closely watched Fed measure is down to 205 basis points. We feel it may be a little premature to assume we’re at the top of the hill at the moment. The discussion will move on at some point not to falling inflation, but to where inflation ultimately settles – 4% will fall short of the Fed’s target and require further tightening. A full throated recession would most likely see inflation at the 2% Fed target.
The markets had approached their 1000 day moving average, a level we deem to be the secular definition of a bull market. After some back and forth, they ultimately bounced from that level as they have on previous occasions. On previous occasions such a bounce typically coincided with more quantitative easing measures from central banks. But that is not the case today. Central banks are very much in reverse gear, and until we see new liquidity infused into markets, the bear is most likely here to stay.
