Long hot summer
Right or wrong, sentiment has shifted from worrying about inflation to worrying about recession. That means rates have stabilised and risk assets are seeing an accelerated sell-off. It could get worse. There could be another increase in rate expectations if inflation keeps disappointing to the upside. Or risky assets could adjust to reflect a move to trend earnings in equities (lower) or previous “wides” in credit spreads. We know what needs to happen for things to get better, but those things are not happening yet. With heatwaves already reported in Japan and much of Europe, it could be an uncomfortable summer in many respects.
A recession will create opportunities for investors, but approaching one clearly creates pain as well. For the recovery, when it comes, quality, growth biased equities and high yield will be the higher beta bets. Quality equities are those that have and continue to demonstrate strong earnings growth. This is a part of the market that has been de-rated but when overall earnings growth becomes scarcer, in a recession, then these stocks will again attract a higher premium. High yield has some way to go before it recovers, as I note below, but yields and prices today suggest better returns ahead.
Recession risks are increasing. Risky asset prices have fallen heavily over the last week and, in the wake of central bankers’ comments in Sintra, it is clear there is no white knight to support markets. Inflation is the key focus of central bankers; investors losing money is way down their list of concerns. At the same time, interest rate and inflation markets are taking the view that what is priced in terms of monetary tightening will be enough to bring inflation down, but in order for that to happen, there also needs to be a cost to growth. It is not showing up to a great extent in current economic data, but the risk is that growth is slowing rapidly, corporate earnings will fall, and defaults will rise.
Recession is not good news for companies
The losses experienced in bond and equity markets since their highs in 2021 can mostly be attributed to the adjustment in interest rates (actual and expected). Now it is all about the impact on corporate cash-flows and valuations. The drawdown in the global bond market is the worst since the early 1970s yet credit spreads are not as wide as they have been. This makes things tricky. Absolute returns are deeply negative, but the relative underperformance of credit compared to government bonds is less than in previous credit bear markets. The US high yield market is a case in point. The absolute drawdown in total returns from the peak in the market in December is around 13%. Since the mid-1990s there were two periods where the drawdown was worse – the global financial crisis and the short-lived liquidity driven panic of the first COVID lockdown. The current bear market is worse than in 2002, 2012 and 2016.
However, in most cycles, the relative performance of credit is worse than the absolute performance. In other words, credit portfolios underperform government bond portfolios. This is because credit bear markets are typically associated with recessions or periods of weak GDP growth. Credit risk rises, pushing credit spreads wider, and then underlying rates fall in response to the growth slowdown, which cements the underperformance of credit. This time around, so far, it has mostly been about rates going up. So absolute performance has been bad but relative performance has, so far, been less bad (6.4% for US high yield). The risk is it gets worse. This would be associated with wider credit spreads and increased defaults and downgrades. The last couple of weeks has seen an acceleration of credit underperformance and deteriorating liquidity conditions in bond markets. This may herald a long, hard summer for credit investors.
Credit and equities
I have been more positive on rates recently and this week has seen a strong performance from rates markets as the recession mindset has started to dominate investor sentiment. However, for credit we need to consider the broader risk environment. Credit excess returns are positively correlated with equity returns. If equity markets fall further, credit spreads are very likely to keep on widening.
Reversion to trend?
How bad can it get? I have commented on the first phase of the equity bear market being a reaction to the shift in monetary expectations from COVID-emergency to inflation-busting. Now, it is about earnings. Taking data on S&P500 earnings going back to 1985, I estimated the trend of earnings over that period. Using a log-estimate (which should capture some of the structural changes in earnings growth given the rise in the share of tech stocks in the index over the last couple of decades), the trend-earnings level for the S&P is around $190 per share. In the most recent quarter, EPS was $200 according to Bloomberg. A reversion to trend earnings (which typically happens in a slowdown) would mean a 5% decline in earnings (rather than the 10% bottom-up consensus for EPS growth over the next twelve months).
Below average ratings?
Valuations in equity markets have adjusted a lot but the US is barely back to the long-term average of 17.5x. An EPS level of $190 with that multiple would give an index level of 3,325 (11% lower than when I wrote this). There are downside risks to this – think about how markets would react to Russia completely shutting down gas supplies to Germany. If the PE ratio fell to one standard deviation away from the average, that would be a rating of 14x and, on trend earnings, an implied level for the S&P of 2,660.
None of this is a forecast or even an expectation. It is just an exercise in thinking what might happen if the global economy does go into a recession. It is also consistent with a more radical view that the world is moving rapidly away from the disinflation concerns of the last 20-years. Covid pushed valuations to extremes in long-duration assets. Now they are adjusting to a world where there is more uncertainty and inflation is likely to be above 2.0% over the medium term. This means there is a big gap between recent EPS levels and estimated trend EPS levels. What’s more, there have only been modest downgrades to forecasts. The gap between the current spreads in credit markets to previous highs is also large, even ignoring the GFC and COVID. Given the beta between the two, another 10% leg-down in equities would mean a 5% or so hit to total returns in high yield. Ignoring carry, that could translate to another 100bp on spread.
The comments above are mostly about the US but the themes are the same in most developed markets, even if they start from different valuation levels. For Europe, the global inflation risks are compounded by geo-political risks and structural weaknesses in the currency union. So even if European equities are cheaper relative to the US, there is still downside risk and European defaults could be more at risk of rising if firms are forced to reduce dramatically their energy usage. Less energy means less production means less revenue.
Some relief from rates
Sequential declines in reported earnings are to be expected in the coming quarters. The risk is that they fall to - or even below - the estimated long-term trend level and that multiples adjust even lower as the equity risk premium rises. The good news is that rates should stabilise – not necessarily because inflation is coming down but because markets will think that central banks will – in the end – care more about growth and stability than getting inflation quickly back to 2%. This is even more so the case when a lot of the inflation is something they can’t do anything about. My call on the government bond markets bottoming in early June remains in place and this week has seen further declines in yield and in inflation break-even rates. This should limit further absolute losses in fixed income markets but relative performance in credit is likely to be negative for a while. But even in credit markets there are positives – average bond prices are very low and carry has improved. Bonds will redeem or be called at or close to par and if they are trading at 90 cents today, that is a healthy return. As I said recently, newly issued bonds (there will be some) will have more attractive coupons and be a source of income to investors.
Risk to risk until there is good news
Bear markets usually need a catalyst to turn sentiment around. It’s hard to see one just now. There is disappointment about inflation not peaking, keeping central bank hawkish rhetoric in place. The situation in Ukraine seems to be potentially worsening as NATO becomes more bullish in response to the atrocities committed by Putin’s forces. Until that situation changes, bearishness will prevail. While I always try to be optimistic, the realism is that only valuations give any sense of comfort to investors at the moment, and we should be prepared for the risk of more substantial losses to come before the inflation/rate/growth shock has fully played out.
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