Ed Smith, Co-CIO of Rathbone Investment Management, examines the recent decline in equity and bond markets but explains why global recession is unlikely.
Key takeaways:
- Globally, stocks and bonds have fallen to levels consistent with recession.
- Yet economic indicators, and growing company earnings and profit margins, suggest otherwise.
- The probability of recession in the next six to 12 months is a far-from-insignificant 30%.
- This is not the case for the UK, however, which is on a much different path than the US and rest of the world.
- The UK’s cost-of-living squeeze is more intense, and households have saved less over the pandemic than those in other nations.
- It seems likely that the Bank of England will be forced to stop tightening faster than investors expect.
- With so much bad news priced in to global equities, we believe it offers compelling opportunities for those who stay invested, albeit a bias to ‘defensives’.
- A big risk is that the supply of gas between Russia and Europe is cut, causing another seismic shift in energy prices, which could push the Continent into recession.
- US 10-year Treasury yield has already risen rapidly, so seems most likely to increase slightly from the 3.0% level of today, especially as core inflation looks to have peaked.
Stocks and bonds have fallen again over past weeks. American and Chinese equities have even plumbed new lows for the year. Many commentators like to post-rationalise short-term gyrations with what, to our mind, is often spurious accuracy. We think it’s sufficient to say that the tumult is the result of the huge amount of economic uncertainty – particularly around GDP growth, inflation and interest rates – that we have written about for almost a year. We had hoped we had seen the bottom, but because we weren’t sure it made sense over the last few months to position portfolios to be more defensive. It was difficult to see a catalyst for any subsidence in the wall of fear that investors have built around how high inflation may go, the scale and frequency of interest rate rises and the prospect of a central bank-induced recession, and the implications of the war in Ukraine.
We must acknowledge that we may not get a catalyst for another couple of months. We probably need to see signs that rates of core inflation (which ignore volatile energy and food prices) have peaked, we’ll need to see further confirmation that wage inflation isn’t going to spiral out of control, and then we’ll need to see the Federal Reserve (Fed), America’s central bank, start to soften its language around the extent of future monetary tightening.
However, importantly, we still don’t think a global recession is the most likely outcome (NB the UK is a different matter), which means neither is a bear market – where stock markets drop by more than 20% and stay there for a long time. If we’re correct, that means the recovery in equity markets is likely to be measured in months, not years. And so it makes sense to stay invested.
Flush with cash
The indicators that anticipate recession the furthest in advance, such as shorter-dated US government bond yields and the inflation-adjusted money supply, suggest a negligible chance of recession. Apart from consumer confidence – whose correlation with actual spending has broken down significantly since the pandemic – shorter-term leading indicators of activity, such as business confidence and intentions to invest in plant, equipment and technology, largely show impressive resilience. This is likely due to all the cash amassed by businesses and consumers over the past two years. We’ve got a decelerating global economy, for sure, but not much sign of recession.
We’ve had yet another good season for corporate earnings: for all the concern about profit margins as input costs have risen, we’re not seeing much sign of deterioration among the largest companies. Almost 80% of companies reporting beat earnings-per-share expectations. In the US, the magnitude of the positive ‘surprise’ is around the non-recession average; in Europe, we’ve seen even better results.
But that’s the quantitative analysis – it’s only ever a starting point. Qualitatively, we’re working under the assumption of a one-third chance of recession over the next 12 months. We’re not complacent. We’re particularly concerned about the war of words between Europe and Russia over trade in energy and the risk of another seismic shift in the price of gas that could precipitate a serious economic contraction.
The good news is that there is a lot of bad news already priced into those companies whose earnings are most sensitive to the business cycle (what we call ‘cyclical’ companies, as opposed to their counterparts, ‘defensive’ companies). The price-earnings multiples of European banks, carmakers and retailers are at seven or eight-year lows, while the valuations of more defensive pharmaceutical or utilities businesses across the world are at seven-year highs. In fact, the ratio of the valuation of cyclicals relative to defensives has only been this low for just three significant periods in the last 30 years. In other words, this is recession pricing. But a recession, in our opinion, is not the most likely scenario so we think there are some compelling investment opportunities right now.
Don’t fight the Fed
There’s an investors’ aphorism that goes, ‘Don’t fight the Fed’. We’re starting to hear it from pessimistic commentators. But ‘don’t fight the Fed’ doesn’t mean sell when the Fed starts hiking rates. The S&P 500 Index has been up an average of 9% one year on from the start of the last 11 Fed tightening cycles (which takes us back to 1967). The average isn’t hiding anything either: the S&P was up in 10 out of 11 of them, the exception being the early 1970s. Historically, and across a variety of macroeconomic conditions, selling at the start of a tightening cycle would have been an almost guaranteed route to substantial underperformance. Of course, past performance doesn’t necessarily mean it will happen this time. But that should give pause to knee-jerk pessimism.
You don’t have to assume that the Fed will achieve a so-called ‘soft landing’ – jargon for calming inflation without inducing a recession. Eight of the 11 episodes in our sample eventually led to recession. The point is that equity markets just aren’t as forward looking as you might think. The headline index level leads the economy by about three to six months, but it takes 12-24 months for monetary policy to fully pass through into real activity. And given that a recession isn’t likely until the real (i.e. inflation-adjusted) interest rate breaches the theoretical ‘neutral’ rate of interest (where policy is neither accommodative nor restrictive), which tends to happen towards the end of a Fed tightening cycle (which last, on average, two to three years) … you get the idea.
‘Don’t fight the Fed’ means that it may not pay to run an investment strategy that banks on falling interest rates if the central bank is at the start of a firmly telegraphed tightening cycle. That’s one reason why we remain very circumspect on speculative technology companies (those that are yet to be profitable) whose valuations could well fall further as real interest rates rise.
