As the new year begins, it is time to take stock of recent developments and look forward to what the year might bring. The past year has been far more eventful than any of us could have imagined at the end of 2021. It started with Russia’s invasion of Ukraine. Inflation rose to levels that were higher than anticipated. Central banks raised rates far more rapidly than anyone expected. Bond markets suffered their worst performance in since the 19th century.
At issue is whether a recession will materialise in the near term, and, if so, what will be its depth and duration? Bond movements have historically been far better at forecasting recessions than humble economists. Indeed, economists rarely forecast recessions. But the past year has been exceptional – both bond markets and economists were pointing in the same direction. The period ahead is without doubt, the most telegraphed recession in history.
Assuming that bond markets and economists are right, the question today is to what extent is this priced into equity and credit markets. Is the worst behind us? Should investors prepare for more pain this year?
Opinions here differ markedly among banks and asset managers. Some would argue that because earnings revisions have not yet reflected a recession, it is premature to think that a floor to equity markets is behind us. Others would argue that by the end of September the S&P had declined by 25%, which is consistent with levels typically seen ahead of recessions. In other words, they would argue that the worst is behind us and that investors should be positioned for an economic recovery.
We find the arguments anchored on past market patterns overly simplistic. Despite last year’s performance, we do not think markets have fully priced in the recessionary scenarios. There are four reasons for our belief:
First, despite all the indications of an imminent downturn, economies have been relatively resilient. Economic data out of the US suggest that the economy is still cruising along at a healthy clip. In Europe, the economic downturn has been far less dramatic than expected. The reason for this is the higher-than-usual levels of savings that consumers were able to amass during the Covid lockdowns, which remain far from being exhausted. Consumption is strong, despite the darkening economic clouds.
Second, bond market performance can be explained almost entirely by the higher rate environment. Credit spreads widened somewhat during the year, but then contracted again. They have not widened to levels that are consistent with the likelihood of higher default rates. Default rates always rise during recessions, the only exception being the Covid-induced lockdown in which governments provided extraordinary support. Companies with high debt maturities in 2023 will face the prospect of needing to refinance much higher base rates. This raises the prospect of significant stress in some areas.
Third, corporate earnings estimates have not been revised down by much. Companies with pricing power can raise prices during this inflationary episode. But whether or not they are able to grow earnings in line with inflation also depends on their ability to manage costs. Earnings are likely to decline more meaningfully in real (inflation-adjusted terms) than in nominal terms. Fourth, the high level of uncertainty around inflation is typically associated with higher risk premia in equity markets. These risk premia have not risen by much, suggesting that the equity market (like the long-term bond market) believes that central banks will be successful in putting an end to the current surge in prices. In other words, the adjustment to Price/Earning multiples that we have seen can be largely explained by higher government bond rates.
Taken together, these factors lead us to believe that last year’s equity market performance does not fully reflect the risk of recession ahead. How should investors position themselves, and where are the opportunities?
In the near term, increasing allocations to government bonds is an attractive option for investors, because inflation data suggests we are close to the point when central banks pause raising rates. There are several forces that are likely to maintain market volatility in the months ahead. First, uncertainty around the timing of the US recession. Second, within the next few months, Europe will need to start the scramble for new gas supplies at prices that may again be very unfavourable. Third, China’s economic growth will resume following the lifting of Covid lockdowns, but policy uncertainty around the housing market will remain high.
While these forces will likely maintain short-term volatility, the longer-term trajectory will be shaped by new economic trends. The transition to green energy in the US and Europe is no longer a climate-related imperative, but a geopolitical one. This argues for an accelerated agenda, but also for the potential for less reliance on international trade. Europe’s border tax adjustment to reflect higher carbon prices can increase trade tension and reliance on domestic production. Similarly, “friend-shoring” of semiconductors and other critical components, is reshaping global trade.
Both trends depend to a substantial degree on the effective deployment of new technologies. This suggests that while the near term is highly uncertain, the medium term is likely to witness a substantial increase in productivity and growth in advanced economies.