Recession Uncertainties Drive Markets back to March Lows!
By Mitchell Anthony
April 29, 2022
Fears of recession have returned to investor’s minds over the last few weeks as inflation data has remained stubbornly high and the already heightened interest-rate environment has taken its toll on demand for housing and autos. The equity markets are now off 13% year to date as measured by the S&P 500 with NASDAQ and secular growth companies nearing a 20% correction or more. This is the same level that markets fell to just after the invasion by Russia into Ukraine and the subsequent problems with food and energy. That sell off ended after calm words from the central bank about the likelihood of a soft landing and their ability to control inflation without a deep recession. While this is still the perspective being offered by Chairman Powell investors can’t help but notice that inflation measures have not rolled over yet despite interest rates of 3% on treasuries and over 5% on mortgages. Chairman Powell is set to speak again next week. Calming words will be well received by the markets.
Are the markets set to break to new lows?
While this is possible it still seems that we will not get a substantial correction from what we have already seen. There is simply nowhere for money to go that leaves the stock market. It will move to cash temporarily as we have done with almost 15% of our portfolio over the last month but those yields are not high enough to keep money there of any size or substance. This has been the case for a very long period of time and Stock investors have enjoyed a very long period of stability in prices and steady growth since the 2009 recession. Interest rates have been near zero for a decade making fixed income a trap for defensive investors. There was volatility in stocks and bonds when interest rates threatened to rise to compete with money in stocks and real estate. However the return on bonds never got high enough to be a real competitor for stock market money. This volatility and associated rise in rates occurred in 2018 after substantial increases in rates by the Fed. It is occurring again now as investors worry about inflation and the 2.7% rates achievable in US treasuries today. Markets will move back to highs as they did previously once inflation is re-anchored and treasury rates return to 1-2% levels associated with the type of consumption that is expected in America.
Recession and/or economic slowdown will be mild
If we get a recession it will be mild but the length is hard to forecast. The US economy has a great foundation with a sound banking system and just-in-time capacity. Unemployment is very low and money is still cheap. There is very little excess capacity in the economy and no visible rot of any sort that would bring the economy to its knees. Markets today are merely discounting the possibility of much higher fixed income rates if inflation fails to subside and the attractions of bonds if rates were to rise from 3% to over 5% on treasuries. The current inflation environment could well drive that rise in rates which is highly unlikely but would be devastating for the equity market. 5% treasury rates would be strong competition for stock market money. This however is not likely as consumer demand is already waning with the current level of rates and inflation seems destined to subside and re-anchor at much lower levels.
The size of the equity market correction we could get now seems to hinge on investor’s expectations for the size and length of the economic slowdown that’s on the horizon. If the slowdown is perceived to be shallow and short no further downside is likely of any magnitude for stocks. If the recession is perceived to be shallow but long, prices may have to fall a bit further to the downside but likely are still close to their lows. If the recession starts to look like it will be deep and long it’s reasonable for another 10 to 20% decline in stock prices to occur.
As stated above growth equities are now testing their March Lows and now we note a break in defensive equity areas such as consumer staples, healthcare, and utilities which are all suddenly off 5 to 10% in just over a week. This is generally a sign of the end of a correction.
Inflation seems set to subside
As inflation continued to push higher over the last few months treasury rates rose from 1 ½% to just under 3%. However this rise in rates has stabilized as visibility of a pause in demand has become somewhat evident. Demand seems poised to fall as softness in housing and autos is beginning to materialize as 5% mortgages and auto loans take their toll on consumption. Inflation has not subsided yet but it appears to be on the immediate horizon. Food and energy prices are still high but have stabilized and demand for services is clearly on the rise both contributing to the high level of prices. Raw materials are still capacity constrained but prices have been stable for several months now. Oil has declined from $130 a barrel to $100 a barrel. This will show up in gas prices soon. However, headline
inflation prints may remain high as food and energy prices remain well above prior
year levels.
Recession seems almost undoubtedly to be on the horizon. This is defined by two consecutive quarters of negative growth in GDP. First quarters GDP was -1.5% and while the second quarter is forecast to be positive that could well slip negative as consumption continues to wane despite record low levels of unemployment and trends in retail sales to all time high levels. The depth and length of this recession is clearly up for debate. How much overcapacity needs to be trimmed from corporate America as consumption eases? Mortgage originators are already announcing some layoffs but employment in the sector was never even close to record levels and hence layoffs will likely be mild to moderate in size. There is lots of uncertainty about what other industries in corporate America are fat with overcapacity. After careful analysis is difficult to find the fat if it exists? E-commerce giants like Amazon added more capacity recently than was needed for the near term but will likely stick with this capacity and avoid any layoffs and the associated costs of bringing those people back after a brief pause in demand. The auto and housing industries would typically be areas you would look to for rot and overcapacity however both of these areas have struggled to get capacity even close to existing demand let alone have excess capacity. It would seem that capacity will finally meet demand in those areas and inflation will subside or turn into outright deflation over the next year.
Economic and Market Outlook
Equities appear to have already priced in a long but mild recession that re-anchors inflation back under 3% within 1 year. Inflation is peaking now and will likely rollover as recession and the related decline in demand unfolds this quarter. Equities are positioned for a substantial rally as softer inflation data and consumption data arrive. Equity markets may tilt a bit lower as consumer demand ebbs and flows over next month but will ultimately turn higher.
Fixed income areas of the market are still not high enough in yield to draw money out of equities. This could change soon if rates have another jump higher but it is still not the case. Fixed income has performed poorly as rates rose and are still not an option for defensive investors, particularly if rates rise further.
As inflation subsides, the Fed will nurture the economy forward and help it avoid deep recession as inflation ebbs lower and his hands free up for policy action.
Stocks are still the most attractive asset class!
We remain optimistic but ready to adapt and change if needed!