By Joseph V. Amato
We believe the onset of a recession is a time to be cautious, but it could also be a time of opportunity for equity investors.
Friday gave us a mixed report on US nonfarm payrolls. The title The number of 315,000 new jobs masked the fact that 100,000 were wiped out in data revisions for the previous two months. Wage growth was unexpectedly moderate and the unemployment rate rose as labor force participation increased. For the first time in several months, people entering the job market cannot find a job.
As strange as it may seem, the recent market turmoil is due to too strong economic data. Inflation is high and should remain so for some time. Therefore, as long as there was job growth, the U.S. Federal Reserve needed to keep raising rates – and markets needed to keep bracing for further tightening in financial conditions.
But perhaps Friday gave us the first signs of a turnaround in working conditions. If so, what could equity investors expect? A deeper and more widespread sell-off as the economic downturn hits in earnest and sweeps the markets? Or something sweeter?
How tight is it tight enough?
We’ve been saying for some time that equity markets can’t stabilize and start a new rally until fixed income markets stabilize. Until Friday’s jobs data, there was little sign of that last week, following Fed Chairman Jerome Powell’s warning in Jackson Hole of “restrictive policy for a some time,” and a string of European Central Bank officials hinting at the possibility of a 75 basis point rate. hike. Stocks retreated appropriately from their recent strong rally.
Bond markets should calm down when central banks signal that financial conditions are tight enough, and we think a key indicator of that will be how those central banks react when job losses start to mount. Will the doves reassert themselves, or will the inflation hawks press for Volcker-style persistence? Powell’s recent speech certainly seems to be setting the world up for the significant downturn he thinks could be in store.
We think the doves will reappear at some point, however – after all, the Fed has the dual mandate of promoting maximum employment and price stability. But relatively strong economic and employment data complicate this picture. In Europe, the scale of the stagflationary energy crisis is making matters worse.
We therefore expect further rate volatility and a weaker economy – and therefore remain cautious on equities.
Our caution due to the current rate uncertainty, however, is very different from our caution due to the anticipated economic slowdown.
When it comes to recessions, sometimes it can pay off to flip the old Wall Street adage by selling the rumor and buying the news. Historically, stock markets have generally bottomed out before the economy bottomed out.
Recency bias can raise fears that the next downturn will be accompanied by a multi-point drop in GDP and a strong double-digit market sell-off, like the COVID-19 and 2008 crises. In reality, the majority of U.S. recessions after World War II have been relatively mild, and there is good reason to believe that the next could be mild as well.
On the one hand, high inflation is likely to mean that nominal growth remains positive throughout, which would support corporate earnings and cash flow, or at least cushion their declines. Corporate debt and interest charges are also generally at subdued levels.
US employment levels are high and job openings remain near an all-time high; and the higher the employment at the start of the recession, the less likely the eventual dip to be. Consumer indebtedness remains modest and savings remain relatively high. All of this appeared to fuel much stronger than expected U.S. consumer confidence data from last week.
The deep recessions of the recent past were triggered by severe economic shocks: a pandemic in 2020 and private sector financial excesses in 2007-2008. Those factors are largely absent this time around.
Consequently, the fall in equity markets could be less correlated and therefore less severe than currently anticipated.
We have already seen signs of this dispersion throughout the second quarter earnings season.
Typically, companies that have pricing power, free cash flow to deploy productivity improvements, flexibility to proactively manage their supply chains, and low exposure to the cost of labor and raw materials are currently favored. They have been able to weather inflation and maintain or increase their share of rising nominal growth, even in the face of falling real growth. Companies lacking these competitive advantages have generally been forced to reduce their forecasts.
We still expect continued volatility and high correlation in equity markets until the shape of the slowdown, inflation outlook and tightening cycle become clearer and bond markets become more stable. But the current uncertainty could turn out to be worse than the downturn itself: as the outlook brightens, we believe that the dispersion of individual company earnings and cash flow should increasingly be reflected in differentiated market prices.
For equity investors, we believe that the onset of a recession is a time to act cautiously, but it is also a time to be ready to seize an opportunity.
In case you missed it
- S&P Case-Shiller Home Price Index: House prices in June rose 0.4% month-over-month and 18.6% year-over-year (NSA); +0.4% month-over-month (SA)
- US consumer confidence: +7.9 to 103.2 in August
- Chinese manufacturing PMI: -0.9 to 49.5 in August
- Euro zone consumer price index: +9.1% year-on-year in August
- ISM manufacturing: Unchanged at 52.8 in August
- US Employment Report: Non-farm payrolls increased by 315,000 and the unemployment rate rose to 3.7%
- Eurozone producer price index: +4% in July month-over-month and 37.9% year-over-year
- Tuesday, September 6:
- ISM non-manufacturing index
- Wednesday, September 7:
- Euro zone GDP 2Q 2022 (final)
- Japan 2Q 2022 GDP (Final)
- Thursday, September 8:
- European Central Bank policy meeting
- Consumer price index in China
– Investment Strategy Group
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