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Downfall Rising

A couple of weeks away from the screens is often a good time for perspective and reflection. Earlier this year the prevailing bias among most investors was extremely cautious and “when all the experts and forecasts agree – something else is going to happen.” As the year has progressed, underlying conditions have remained resilient and the S&P500 (global risk proxy) has advanced, consensus beliefs have capitulated on the pessimistic outlook.

The prevailing bias among most investors was that recession and weaker earnings would compromise equities in the first half of 2023. From our perch, the downside risk to growth was always likely to be later this year rather than in the first half for three reasons; 1) it takes time for policy tightening to impact the real economy; 2) liquidity support (easing) during the regional banking crisis probably assisted risk assets in the June quarter; 3) excess savings and liquidity from the post-2020 recovery was still supporting the economy and 4) pessimism was the widely held consensus belief. As we noted a few months ago, the liquidity support provided during the regional banking crisis was likely to reverse in the second half and there now is a divergence between the Fed liquidity and the S&P500 (chart 1).

Since 1957, there have been ten recessions and two soft landings. Eleven of the twelve periods of weakness were preceded by a sharp rise in policy rates that inverted the 6 month/10 year US Treasury yield curve. There were two soft landing environments - 1966 and 1995. In both episodes, the market was weak and economic activity slowed after aggressive policy tightening, but recession was averted.

From our perch, the odds of a soft landing remain low for three reasons. First, the Conference Board leading economic index is significantly worse than 1966 and 1995 (chart 2). The Conference board leading index of 10 economic indicators has declined for 14 consecutive months. In each episode when the index reached the current level, the economy was in or about to enter recession.

Second, the two soft landing episodes were preceded by a sharp drop in rates. That does not exist today. In 1966 and 1995 the 6-month US Treasury yield peaked before the low in the stock market. That is clearly not the case today. On a related point, the median duration between the initial inversion and recession is around 11 months. The big picture point is that is only now just at the point where it is becoming more likely. From a behavioural perspective, price and beliefs have also capitulated, where a “soft landing” has become the prevailing bias and the dark side (sell side) of the Force have raised index and earnings revisions. The capitulation in consensus beliefs is also evident in the drop in demand for protection over the past few months and a range of investor surveys (“soft landing” was consensus in the latest B0fA Fund Manager Survey).

Third, the latest senior loan officer survey (post the regional banking crisis) saw a further tightening in lending standards, especially for small companies. Historically that has been consistent with a deterioration in credit growth, profits, employment with a 12-month lag. It is also consistent with a non-trivial rise in default rates. In that context, the US high yield credit spread (risk premium) remains too narrow (chart 3). In contrast, credit spreads in EM/Asia are already at distressed levels.

On fiscal policy. A key element in this cycle was the extremely aggressive fiscal easing combined with monetary easing. That also reversed over the past year (chart 4). Recall it is the change in fiscal policy that contributes to growth. Note that the deficit (rate of change) has increased again over the past two quarters. Ironically, the wider deficit could partly reflect the slowdown in revenue now underway. Put another way, a recession later this year probably reduces the odds of any fiscal improvement later this year.

The final point to note is that even if you are optimistic on a benign business and profit cycle, risk compensation in US equities and credit is around zero relative to duration free money market yields. Put differently, the earnings yield on US equity and the corporate bond yield is inferior to short-dated Treasury Bills. From a timing perspective, our sense was that the next drawdown phase for equities was in the August-October time frame, after price had rallied in the June quarter and consensus beliefs had capitulated on the cyclical outlook. We reduced our net long equity exposure in July and remain light and tight.


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