Recession fears are rising everywhere, both on Wall Street and in Washington. Fed eonomist Michael T. Kiley formulated a recession model based on unemployment rates. The probability of a recession over the next four quarters is now over 50%, but the economy has never avoided a recession when readings were this high.
The New York Fed’s DSGE model
, which does not represent its official forecast, puts the chances of a hard landing at 80%. There are numerous other examples. That’s just two of them.
Recessions are supposed to be negative for stocks, right? Yes, most of the time. Even as recession anxiety rises, the omens from the sector and factor gods are telling a different story for the stock market.
The macro downgrades shouldn’t be a surprise. The US Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations, has been tanking.
Wall Street strategists are scrambling to cut top-down earnings estimates. As an example, Ian Harnett of ASR penned an op-ed in the Financial Times
that indicated the risk to equities isn’t interest rates, but earnings.
The current data signal a synchronised slowdown around the world. Rather than uninterrupted earnings per share growth, our models point to an earnings recession in the year ahead. We expect US earnings to fall by an 10 to 15 per cent over that time.
Perhaps even more impressive is that the consensus EPS forecast for the Euro Stoxx index companies is signalling increasing earnings expectations despite the war in Ukraine and a cost of living crisis that is likely to raise costs and reduce demand for corporates. Our “top-down” forecasts suggest that eurozone EPS could fall by an annualised 20 per cent in the year ahead.
A recessionary slowdown is now becoming the consensus call.
Bad news is good news
Ironically, bad news is becoming good news for risky assets. Jerome Powell stated in the last post-FOMC press conference
that the Fed is increasingly focused on headline inflation rather than core inflation as a guide to monetary policy. It sounds like the political press to control inflation is heating up.
People, the public’s expectations, why would they be distinguishing between core inflation and headline inflation. Core inflation is something we think about because it is a better predictor of future inflation. But headline inflation is what people experience, they don’t know what core is.
Here’s the good news. Energy and food prices are falling. The point and figure chart of crude oil violated a key uptrend.
Wheat prices peaked in May and they have been weakening since.
These developments are welcome news for policy makers. It’s an indication that inflation pressures are beginning to top out. Moreover, falling grain prices serve to alleviate hunger in much of the world as the Russia-Ukraine war has restricted global cereal exports.
In response, bond yields have begun to fall in response to expectations of slower growth.
Improved risk appetite
A review of sector and factor returns in the US equity market was highly revealing of changes in market psychology. Even as the S&P 500 fell to fresh lows in June, the relative performance of defensive sectors failed to make relative highs, with the exception of healthcare.
Growth stocks are starting to show some signs of life. The relative performance of growth sectors are all trying to bottom even as the S&P 500 probed new lows for the year.
The relative performance of value sectors tells a different story. Resource extraction sectors such as energy and materials have fallen hard against the S&P 500, while the relative performances of other value sectors have traded sideways. The cyclically sensitive equal-weighted consumer discretionary sector is in a well-defined relative downtrend.
The returns to the quality factor have been unexciting, which is a surprise as quality stocks tend to outperform during periods of economic stress.
From a market cap perspective, the mega-cap S&P 100 and NASDAQ 100 have suddenly surged relative to the S&P 500, while mid and small-cap stocks have trended sideways to down.
I interpret these conditions as signs of bearish exhaustion. As bond yields decline in anticipation of slower growth, high-duration plays such as large-cap quality growth are making a comeback. It’s difficult to forecast how the intersection of likely falling earnings estimates and declining yields will play out for equity prices, but the market reaction has been constructive so far.
Fading geopolitical risk
Another piece of good news for equity investors is a fading geopolitical risk premium. Despite the shock of the Russia-Ukraine war and the risks it poses to the European economy and global hunger, the market appears to have digested much of the risk.
Consider Poland, which is located on Ukraine’s western flank. The performance of MSCI Poland has stabilized, on an absolute basis and relative to European and global equities (all returns are in USD).
Turkey is on the southern flank of the conflict. Despite well-publicized problems with inflation and a falling currency, MSCI Turkey has performed well in a difficult environment and it’s in a relative uptrend compared to Europe and global stocks.
The onset of the Russia-Ukraine war has led some analysts to voice concerns about a Chinese invasion of Taiwan. While MSCI Taiwan recently broke support on an absolute basis, it’s performing well when compared to EM xChina and global stocks.
In case you missed it, my recent market bottom call has been highly controversial (see Why last week may have been THE BOTTOM
). Even though a recession has become the consensus view among strategists, the market is not reacting to the negative news. A review of sector and factor returns shows a constructive return of risk appetite. While it’s impossible to know if another shock could spark another risk-off episode, the long-term risk/return outlook for equities is becoming more attractive at these levels.
The key risk to watch is whether the BOJ can continue to buck the trend with an easing policy even as global central bankers tighten. JPYUSD has fallen dramatically, which raises the risk of a currency war in Asia. Already, Chinese sovereign bonds are now yielding less that Treasuries, which is putting pressure on China to devalue. Other Asian currencies, such as INR< PHP, and KRW have also weakened, which are worrisome developments.