As the northern hemisphere summer rally unfolded, we warned that it was probably a counter trend (bear market) one and maintained a defensive bias in our portfolios. A sustainable momentum shift higher has typically only been associated with the Federal Reserve easing policy (and liquidity) rather than continuing to tighten. History suggests that the direction from current levels is likely to be driven by the prospect of a profit recession. Unfortunately, the Fed is expected to nearly double the funds rate from here into a levered system, surging inventory levels and deteriorating global final demand. That increases the probability of a genuine contraction in corporate earnings.
While consensus beliefs and positioning have clearly become very pessimistic over the past few weeks and especially since the hawkish language post Jackson Hole, equity risk compensation in the United States is only around the historic average. Moreover, as we have highlighted over the past few months, the tightening in financial conditions (and liquidity) is already consistent with a deep contraction in output and earnings (chart 1). Put another way, the best leading indicators of the macro cycle are consistent with an outright recession, especially if the Fed continues to tighten financial conditions. The drop in real liquidity or the difference between output and money supply is also consistent with a genuine recession. That observation is also supported by the yield curve.
Although current conditions in the US labour market remain robust, with the unemployment rate still near the historic low. The tightening in financial conditions and other leading indicators like small business hiring plans are consistent with a surge in unemployment over the coming months. For equities, higher unemployment is consistent with profit margin compression and recession. From our perch, corporate profit margin compression is most likely to be associated with lower demand rather than rising costs, but both have likely been contributing factors in the current episode.
For the US stock market (the global risk proxy) the most optimistic scenario is moderate revenue growth and some margin compression in most sectors given the probable slowdown in top line growth and elevated inflation. On the positive side, we would not want to become too negative toward risk assets because it is plausible that weaker economic growth over the next few quarters will likely lead to an actual pivot rather than a perceived pivot by the Fed.
For Asia, there a few key points to note. First, risk compensation (or valuation) has already discounted a much more pessimistic outlook. Second, an actual pivot (rather than a perceived pivot) would probably coincide with a correction in the US dollar (which is positive for Asia/EM). Third, credit and liquidity has already started to improve in China, albeit a policy pivot away from COVID zero would clearly be helpful in November. The final point to note is that the relative discount of Asia to the United States is the most extreme since the 1997 Asian crisis.