MON 04 JUL 2022
A cliché we often hear is that markets hate uncertainty. That tends to wind us up because markets are always uncertain as human beings cannot see the future. It is a key reason why it is generally better to work out what is probably wrong, rather than to forecast what might go right. Markets are forward looking and will tend to discount or anticipate shifts in macro conditions.
Clearly the major shift in consensus beliefs over the past few months is the pivot from discounting inflation and interest rate risk to (downside) growth fear or recession. Historically, expansions tend to last until the Fed increases the policy rate above neutral. While neutral or equilibrium is fiendishly difficult to estimate (even in hindsight) what we do know is that risk assets have tended to struggle when the money markets have priced 3%-4% nominal rates.
Stated differently, we know that policy is restrictive when something breaks. Arguably, a 20% drawdown in global equity and worst start to the year since 1970 suggests that risk assets are broken. Of course, the additional challenge interpreting the price signals in recent episodes has been the complication of unconventional policy (QE, forward guidance) and the nature of the pandemic/European conflict on the supply side of the economy.
While there is now a widespread discussion of “recession” and a shift in the prevailing bias to growth fear, consensus earnings and profit margin estimates are still heroically optimistic. The tightening in financial conditions is now the most rapid (in rate of change terms) since 2008 and the fall in ISM manufacturing new orders less inventory suggests that the odds of an earnings recession is uncomfortably high (chart 1). Put another way, absolutely nothing is certain in financial markets, especially macro, but I am not uncertain on the risk of a recession.
As we reinforced last week, all of the adjustment in equity prices so far this year have been via valuation multiple compression. In contrast, forward earnings estimates have been positive so far in 2022 and profit margins are still near peak levels. Moreover, while the contraction in valuation has been brutal, the US stock market is only back to neutral rather than at distressed levels. Similarly US high yield spreads at 580 basis points are only modestly above average. In a recession, junk bond spreads tend to trade over 1000 basis points. The big picture point is that there is more downside risk to equity and credit if there is a profit recession.
The recent price action in the interest rate markets suggests aggressive rate hikes now equal rate cuts later, with the December 2023 Eurodollar implied yield now trading through the December 2022 contract (chart 2). That is also probably consistent with the decline in ISM new orders and the tightening in financial conditions noted above. As we noted last week, there has also been a material correction in commodity prices that will ease headline inflation risk over the coming months. However, we would also note that the largest consumer of most industrial commodities – China – is easing credit and liquidity. If the current growth fear is misplaced the set up for commodity linked equity might be bullish later this year.