Legendary investor John Templeton once said:
Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
Where are we in the market cycle? From a long-term perspective, the S&P 500 is wildly oversold on the monthly MACD histogram, but the 14-month RSI has retreated to a neutral reading. Market psychology has shifted from FOMO (Fear of Missing Out) to GIDOT (Glad I Don’t Own That).
Much depends on the Fed, interest rates, and the earnings outlook.
A determined Fed
The behavior of the stock and bond markets has seen a shift in tone over the past few weeks. The S&P 500 fell for much of 2022 and the 10-year Treasury yield has been rising in lockstep, indicating bond market concern over Fed hawkishness. In the last two weeks, bond yields peaked even as stocks weakened and the 2s10s yield curve flattened. Market psychology has changed from a fear of rising rates to the fear of an economic slowdown, which is the second phase previous specified in my publication, A 2022 inflation investing tantrum roadmap.
Much depends on where the Fed is in its hiking cycle. Fed Chair Jerome Powell made a series of recent media appearances. In a WSJ interview, Powell reiterated the Fed’s determination to fight inflation, “Restoring price stability is an unconditional need. It is something we have to do. There could be some pain involved.”
In a Marketplace interview, Powell underlined the message that “the process of getting inflation down to 2% will also include some pain”. More importantly, he considered the risk of elevated inflation more important than the risk of a recession.
I think it’s a very challenging environment to make monetary policy. And we certainly, our goal, of course, is to get inflation back down to 2% without having the economy go into recession, or, to put it this way, with the labor market remaining fairly strong. That’s what we’re trying to achieve. I think the one thing we really cannot do is to fail to restore price stability, though. Nothing in the economy works, the economy doesn’t work for anybody without price stability. We went through periods in our history where inflation was quite high. This was back in the ‘70s, and I was old enough to remember. I’m old enough to remember that very well. And we really, we can’t fail to restore price stability.
In other words, the Fed is willing to drive the economy into recession in order to wring inflation and inflation expectations out of the system. A soft landing would be nice, but it’s not necessarily the objective.
So a soft landing is, is really just getting back to 2% inflation while keeping the labor market strong. And it’s quite challenging to accomplish that right now, for a couple of reasons. One is just that unemployment is very, very low, the labor market’s extremely tight, and inflation is very high.
Much will depend on wages.
For example, in the labor market, there’s more demand for workers than there are people to take the jobs, right now, by a substantial margin. And, because of that, wages are moving up at levels that are unsustainably high and not consistent with low inflation. And so what we need to do is we need to get demand down, give supply a chance to recover and get those to align.
Powell gave a nod to events outside the Fed’s control, such as the inflationary pressures caused by the Russia-Ukraine war and China’s COVID lockdowns in his WSJ interview.
Still, the Fed as recently as January had expected inflation to diminish this spring as supply-chain bottlenecks improved. Russia’s invasion of Ukraine in late February and rolling Covid-related lockdowns in China created new sources of inflationary pressure.
“That is going to make it harder for inflation to come down, so it has added a degree of difficulty to what was already a challenging market,” said Mr. Powell.
A monetary policy report card
Let’s take a look at an interim monetary policy report card. Two consecutive half-point rate hikes are baked into expectations in accordance with Fed communications. While the market is leaning towards a third half-point hike at the September FOMC meeting, the probability is less certain.
Here are some of the metrics the Fed is considering. Wage growth is soaring, though the less educated and lower paid workers are receiving the most. The distribution of the gains is constructive as this represents catchup from years of lagging growth.
New Deal democrat has been calling for a slower jobs market because real retail sales leads employment. While that hasn’t shown up in the monthly Non-Farm Payroll report just yet, initial jobless claims are bottoming, indicating a cooling jobs market.
Even though the transitory word has been erased from the Fed’s vocabulary, inflation, as measured by core PCE, is cooling. Both core PCE and the trimmed-mean PCE have been decelerating in the past three months and annual PCE should fall as large readings drop off in the next three months. All else being equal, core PCE is currently running at an annualized rate of 3.0-3.5%, which is below the Fed’s SEP projections of 4.1% by December 2022.
Monetary policy is doing its job of tightening financial conditions, though readings are not at past crisis high levels. Various Fed speakers have made it clear that there is no Fed Put in the stock market. What the Fed cares about is the proper functioning of credit markets and excessive Wall Street turbulence doesn’t leak over to Main Street.
As well, inflation expectations have improved, which makes the Fed’s job easier.
The stock market’s reaction
Here is the stock market’s view. The S&P 500 is trading at a forward P/E of 16.4, which is below its 10-year average of 16.9. In the past 10-year, similar levels of the 10-year Treasury yield has seen the forward P/E in the 14-15 range, with a panic low of 13.5. This translates to an average downside risk of 10-15%, though it could fall as much as -25% if the market panics.
In effect, the market is discounting a soft landing, which is consistent with Jurrien Timmer‘s choppy market scenario of 1994, 2015-16, and 2018. That’s the rosy scenario.
Here is the ominous scenario. The Misery Index, which is the sum of CPI and unemployment rate, is rising in the US and Europe.
Eurozone consumer confidence is at levels consistent with recession sin the past.
The European economy will further be pressured by the additional imposition of sanctions on Russia. In addition, food shortages will become an additional source of global instability as summer progresses. The Russia-Ukraine war has closed Ukrainian grain exports through the Black Sea. In Asia, China’s wheat crop is expected to be very poor because of a delayed planting and the heat wave in India has sapped grain production. Moreover, Europe is expected to experience a dry summer and create drought-like conditions in wheat growing regions like France.
The outlook for North America isn’t much better. The UKMO model calls for dry conditions over most of the cereal growing regions in central and northern US and southern Canada this summer.
As well, Europe and North America is expected to see a hot summer, which would boost air conditioning usage and natural gas demand and add to inflationary pressures.
Recession ahead?
For investors, much will depend on whether the Fed is at peak hawkishness and if the economy falls into recession. The best-case scenario will see inflation peaking out this summer, a cooling of wage pressures, and no further supply chain disruptions. The S&P 500 forward P/E valuation of 16.4 is adequate.
The risk is the economic outlook slows further and Wall Street cuts earnings estimates. While forward 12-month EPS estimates haven’t fallen so far, a recessionary scenario will see analysts cut EPS estimates, which has caused past turbulence in the past.
The dismal financial performance of Target and Walmart shows the lingering effects of the COVID Crash and recovery. Both retailers reported that sales were up, but profits were down and inventory rose. The inventory increase is partly a result of the over-ordering effect because of COVID supply chain disruptions. As bottleneck pressures eased, deliveries rose, which boosted inventories and reduced margins.
Ben Carlson pointed out that recession bear markets are far more vicious than non-recessionary bears. If the economy were to sidestep a recession, investors may have seen the worst of the equity decline, but there could be substantially more downside risk if the economy were to collapse into recession. That said, any recession should be relatively mild, as both household and corporate balance sheets are strong. Deep downturns are attributable to the combination of economic weakness and excessive leverage, which is not evident in the US, though it can be found in some non-US economies. So far, the S&P 500 is down -20% in 4.5 months, or about 135 days.
In conclusion, the US equity outlook depends on the economic outlook. P/E multiples are adequate if the economy sidesteps a recession, but the risks are skewed to the downside. If the Fed becomes more hawkish, the economy collapses into recession, or if further supply chain disruptions pressures inflation, downside risk could be considerably higher.
Cam- What’s your outlook for bonds in the event of a recession?
Bond prices should rally in a recession.
It seems like a good entry point for bonds, but I am reminded of Larry Summers recent interview with Ezra Klein where he essentially says the Fed will need to tighten for more than they think.
Still, if core PCE is running at 3-3.5% the end of the tightening cycle may be closer than it feels.
Will have to think on that…
Cam,
Since December 2021, the analysis and conclusions have been spot on. The multiples have contracted to a fair level, given the current interest rates.
The risk going forward is to earnings estimates and a further contraction in multiples.
Jurien Timmer thinks that the chances of a recession are low. Others place the odds at 50% and even a certainty in 2023. Fed is not, at least right now, worried about causing a recession with the monetary policy.
Global economic outlook is less than rosy. China is going to start opening and stimulating their economy.
How do you think about this? What are your estimates of the chances of a recession, mild or deep(Grantham)?
What areas (in addition to long duration bonds) should one consider for the equities in a recessionary environment?
Thanks.
Clarifying: Fed is not worried if they cause a recession due to monetary tightening.
Jury is out on a recession. New Deal democrat thinks there may be a recession starting Q2 2023, but to call it now would be jumping the gun. It’s clear that we will get a slowdown. Whether the US economy falls into recession is still a matter for debate. Globally, the eurozone is far more likely to go into recession and China may already be in one now.
In equities, you may want to consider the quality pairs that I highlighted before, such as long S&P and short Russell, either in large or small caps.
In all of the above, please factor in China going to war over Taiwan.
While one may think it is a minor possibility, so we did for Ukraine war as well. Looking back, Ukraine war proved to be a 100% probability. Near 100% analysts were wrong at estimating this probability. Sure, my words sound harsh and biased now that I know the history.
There are so many known challenges which keep us occupied that we ignore those lurking in the background. Our minds can only deal with so much.
What worries me is how to navigate the daunting terrain? Hide in cash till it blows over? Commodities? Bonds? Equities? I am an optimistic by nature but the macro has changed fundamentally in recent months. I don’t know if we will have accommodative Fed tailwinds any time soon.
Yesterday I ran my search engine, just for fun. There is one interesting post about Jimmy Bullard. In an interview he stated that Fed should adopt heavy front-loading in raising rates so that Fed can cut rates in 2023.
In NoCal PG$E started to warn that there will be rolling blackouts this summer. And yesterday they sent out an email encouraging people to participate in rewards program if they cut power usage this summer. And then Ca state gov is encouraging people to switch to EV to avoid high gas prices.
Drought is a serious problem in Ca besides power shortage. But Ca gov just got rid of one large desalination plant project.
Just maximum randomness, in gov thinking.
As a fellow Californian, I agree that turned down the desalination plant makes zero sense. Why not marry reusable energy projects to desalination? Why not build new water storage with smarter hydroelectric capability? Why not force smarter choices around water use and farming (do we really need so many almonds?)? The time is now.