Investor sentiment is going through a sea change. Last September, markets were extremely pessimistic and investors were positioning for a recession. The gloom even took us bears by surprise! We moved to be tactically bullish at the start of the fourth quarter, adding substantially to equities and credit, despite sharing this very pessimistic view, as valuations were far more attractive. Now as we enter 2023, sentiment is shifting and markets are more buoyant, reacting to the upside. We have seen an impressive ‘rally in everything’ off those September lows and this January alone has delivered significant returns across all asset classes. The question investors are now confronted with is whether this is simply a (rather impressive) bear market rally, or the start of a durable new bull market.
Have the storm clouds cleared?
The rally started late last year as investors started to see inflation roll over. Commodity prices have fallen, which will lead headline CPI lower. COVID supply chain shocks are being resolved and manufacturing delivery times have improved, aiding a reduction in goods inflation. This is all good news. However, the services side (the more sticky component of core inflation) continues its upward trajectory. This is due in a large part to a very strong labour market, experiencing low unemployment, pressuring continued wage growth. Not to mention the consumer is still buoyant thanks to excess savings which is leading to continued consumption, which while decreasing, is still well above trend. This has meant the economy has remained more robust than expected, with US Real GDP rising 2.1% in 2022 and equity earnings, while muted, continue to deliver.
The bond market is also helping, pricing in three 0.25% rate cuts in the back half of 2023. Markets read this as inflation will moderate down to acceptable levels and that growth will slow but not enter a recession. This is essentially a “Goldilocks” scenario of low but moderate growth and inflation. This has further helped equities by allowing longer-term bond yields to compress, providing a boost to equity multiples. If we assume these rate cuts come to fruition, perhaps the current price-to-earnings ratio of 20x can be justified (low rates allow for higher P/Es and vice versa). While there is no precise definition of a soft landing, avoiding a recession typically implies GDP growth of around 0-1%, which translates to around 0% earnings per share growth in equities. This would place the fair value of the US S&P 500 at around 4100, a hair’s breadth away from the January 2023 close. The market has spoken, welcome to Soft Landing Island!
Or is this merely the eye of the storm?
But could it all really be over? Will the carnage of 2022 become a distant memory as life goes back to normal? Timeframes matter for investors and unfortunately we have been a little bit spoilt over the past few years. I’m not going to sit here and say the Global Financial Crisis of 2008 or the COVID market shock of 2020 were easy – far from it. However, these events were crises and have conditioned us to believe bear markets are vicious but quick and that policymakers will step in and defend the economy and asset prices. If we look further back, bear markets usually take far longer to play out. It took almost three years for the stretched valuations of the Dot -com Bubble to deflate. The period from 1965 to 1975 saw swings of +/- 50% as inflation became unanchored, but essentially equities traded sideways for a decade in nominal price terms. Investors today think in terms of months, not years, and are already showing signs of fatigue one year into a valuation reset and potential inflationary recession.
I mention this because understanding timeframes may prove to be crucial to understanding the current macro regime. The post-COVID economy has been extremely strong. We have seen unemployment fall to levels last seen in the 1960s and similarly inflation rise to levels not seen since the 1980s. This has led to an aggressive rate hiking cycle by central banks around the world, which in turn has led many (including ourselves!) to believe this will crush demand and the economy will eventually roll over into recession. Current hard data (lagging indicators) shows the economy is still growing, whereas soft data (leading indicators such as purchasing managers indices (PMIs)) are signalling recession. Typically, monetary policy has a lagged effect on the broader economy and can take 6 to 18 months to make an impact. However, less than one year in, many were expecting the hard data to roll over by now. Instead, the data is rather mixed – it’s slowing but not collapsing and is being viewed as a sign we will avoid a recession and that we’re heading for a soft landing. Those who follow the soft (leading indicators) data believe the recession is still the most likely outcome.
While inflation is moderating, the sticky component remains high and will potentially force the Fed to keep rates higher for longer, which we think is not being priced by the market. Historically, inflation is hard to control and can often resurge after policymakers believe their job is done. The double hump inflationary period of the 1970s is a clear case of how hard inflation can be to control. The recent rally in risk assets has eased financial conditions, which can lead to another bout of inflation, which could further complicate the reaction function of central banks. With core inflation still above 5% and policy models that use labour market data suggesting policy rates should be much higher (circa 8%), the Fed may be pausing prematurely if the labour market does not falter. The COVID policy pivot in China may also add fuel to the fire as 1.4bn people with pent-up demand unleash their spending onto the world. While the market focuses the debate on a soft landing or a recession, a resumption into a higher inflation path is a significant risk not being priced at all.
Waiting for the leading indicators to improve
Leading indicators remain weak. US PMIs have fallen below 50 (i.e. indicating contraction), the ISM New Orders Index has fallen even more to 42.5 and the National Association of Home Builders Market Index almost hit the COVID lows of 30. While earnings are not collapsing, the speed of downgrades is picking up steam and our forward-looking models suggest an earnings decline of 15% is likely, which is in line with a standard or moderate recession. The yield curve remains deeply inverted (a strong recessionary signal) and our US recession model has 65% of the 20 indicators flashing recession warnings, the highest percentage back to at least 1990.
While it’s fair to say our base case remains recession, the waters continue to be muddied. Data releases appear to have something for everyone, bulls and bears alike. Even the 75bps of cuts could be viewed as the bond market pricing in a 40% chance of a 2% rate cut as a recession begins in earnest. The future is likely to remain opaque until we either see soft data improve (a usual indicator the bottom is in) or the hard data turn down (confirmation of a recession). At the same time, seeing where inflation settles remains paramount. Until inflation is contained, strong data will pressure the Fed to keep rates higher for longer, potentially leading to a policy mistake if they misjudge the timing of the lag between their actions and the impact on the economy. In the meantime, while we wait for new data points to come to light, or more compelling valuations to provide a higher margin for error, we focus on trading the probabilities.
Staying nimble and active
After being bearish most of last year, we became concerned that our narrative had become consensus thinking in the early fourth quarter of 2022. Our estimate of fair value for the S&P in a recession was around 3200-3400. After hitting 3600 in late September and early October, we felt the market had another 5-10% to go, but was close enough to pricing in our shorter-term base case. Valuations and risk premia had been restored but were not yet screamingly cheap. US investment grade credit spreads hit 110 and high yield spreads breached 600. Positioning and sentiment was primed for a market reversal, so on the balance of risks we favoured the upside and those levels provided safe entry. We therefore added 10% to both equities and credit.
Today, the market has priced in a soft landing, positioning has turned more positive and sentiment indicators like the Fear & Greed Index are back to extreme greed. While the macro view may turn out to be right, it is mostly priced at current levels, and the damage in the leading indicators suggests the risks are now to the downside. We have therefore taken partial profits, selling 5% in equities and entered into a strangle, which is an options strategy to benefit from large moves in either direction. We have maintained our investment grade credit exposure for high quality carry as we potentially chop around in no-man’s land until the data confirms the trajectory of the economy one way or the other.