The Market Isn’t Waiting for the Economic Data to Rollover
There is no easy way to put it. June was an abysmal month for global financial markets. The S&P 500 lost -8.8% of its value to close the worst first half performance since 1962. The S&P 500 finished June down -20% for the year and from its peak. To the further consternation of investors, the bond market has not provided any measure of relief. The Bloomberg Aggregate Bond index ended June down -10.4% for the year.
The driver of these poor performances was initially inflation as we have commented previously. A change occurred, however, during June with the Fed’s very hawkish comments after the higher-than-expected May CPI report. In short, the market has become less concerned about inflation and more concerned that the Fed will tighten too much and drive the economy into recession. Remember, the market is forward looking and despite exceptionally strong economic data today of which we will discuss further below, the market began to price in a recession during June.
In our analysis, the S&P 500 tends to decline on average approximately 35% during recessions. During crises, such as the Great Financial Crisis, the market can drop even lower, but we do not see any evidence of conditions that support the development of a crisis at this time. To the extent that a typical recession emerges, it is entirely possible that the market could decline a further 15% from current levels. Therefore, we believe it is too soon for investors to aggressively buy this dip. Nevertheless, with 62% of the stocks in the S&P 500 index trading within 15% of their 52-week low and nearly one third down over -25% YTD, there are quite a few bargains emerging. The bargain hunting, we believe can also extend into higher grade fixed income, such as Treasuries, MBS and investment grade corporate bonds as yields have increased to more attractive levels and could also now provide a measure of safety.
Market Update
June’s sell-off across virtually all asset classes exhibited classic “risk-off” characteristics, particularly towards the end of the month. The magnitude of the sell-off left the market in an oversold position and signaled some level of investor capitulation as the market partially priced in a future recession.
The S&P 500 finished the month down -8.8% and the Dow and Nasdaq similarly closed June down -7.2% and -9.0%, respectively. Fixed income struggled as well with the Bloomberg Aggregate bond index closing down -2.5%. The riskier the bond, the further it fell. The Bloomberg High Yield index fell -7.8% as credit concerns and higher potential defaults were priced into that market. Commodities, which have been among the few bright spots in global financial markets this year, fell prey to the recession “playbook”. The Bloomberg Commodity index fell -12.6% for the month but remains up 18.0% for the year. Strong corrections like this one are commonly found when normal profit-taking is compounded by changing economic sentiment. In short, when recessions occur, demand destruction for commodities can occur. In our opinion, the size of the commodity pullback does not square with the fundamental structural supply problem facing oil, natural gas, soybeans and corn.
We discussed last month how The Conference Board’s survey of U.S. consumers showed recessionary levels of pessimism regarding future stock market performance[1]. Another poll indicated that a majority of Americans think the economy is already in a recession[2]. As shown below, the University of Michigan gauge of consumer sentiment also indicates exceptional levels of pessimism about the economy[3]. In fact, consumer sentiment has never been this low since polling began in 1977. Lower than the brutal early 1980s recession. Lower than 9/11, the Global Financial Crisis and the Pandemic. We were happier when mortgage default rates were 30%, the stock market was down 50% and unemployment was over 10% (which occurred three times!) But give us $5 gas, food inflation and a host of political and foreign policy miscues and Americans are downright depressed. An AP-NORC poll released last week revealed that 85% of US adults say that the country is headed in the wrong direction[4]. In our view, the consumer’s pessimism is only dragging down investor sentiment, but we are beginning to wonder if perhaps both are too pessimistic. The contrarian (or perhaps the optimist) in us has us pondering an important question: “What if the economy is not so bad?”
Are We in a Recession?
No. At least not yet. According to the National Bureau of Economic Research, which is the nonpartisan group responsible for determining when recessions begin and end, the definition of a recession goes beyond the simplistic popular notion that GDP must decline two quarters in a row. Rather, “a recession involves a significant decline in economic activity that is spread across the country”[5]. The decline in activity must not be confined to a single sector and be evident in economic activity, including real personal income, nonfarm payroll employment and real personal consumption expenditures.
By nearly all accounts, the U.S. economy is currently exceptionally strong. Consumer spending remains at record levels according to Census Bureau and Bureau of Economic Analysis data[6]. A critical driver of this spending is one of the strongest labor markets since World War II. According to the Bureau of Labor Statistics, the unemployment rate is currently 3.6% - the third lowest since the 1940s[7]. Continuing unemployment claims of 1.3 million are at their lowest level since 1969 and well below the 2 million on average during the period 2015-2019[8]. Furthermore, job openings remain near record levels at 11.4 million[9]. The robustness of the labor market means that workers are employed and earning income to support their purchasing behavior.
But this could all change. In the coming weeks, public companies will report their quarterly earnings and will accompany these announcements with guidance for future earnings. While these reports are always important, this earnings season will receive a special level of attention and, in particular, the guidance within them. As the market is forward-looking which means it prices assets today in anticipation of future earnings, the pullback experienced this year is largely attributable to the market anticipating worsening earnings in the future. In recessions, those future earnings can be significantly negatively affected with certain businesses more susceptible than others. The consensus today is that some combination of reduced demand and high input costs will cause operating margins to shrink at many businesses thereby leading to lower earnings guidance. When face with lower earnings, some companies may choose to layoff workers and/or freeze hiring – a tactic that we have witnessed many times before. Therefore, it is quite possible that the labor market and consequently consumer spending could be at the very beginning of declines that could ultimately lead to a recession.
Outlook
Our base case for the economy is not as bleak as the market seems to believe. We do believe that the goods portion of the economy, particularly those goods that became especially desired during the last two years of social mobility restrictions, will face recession-like headwinds. The combination of the burst in demand pulling forward sales from future periods, higher financing costs and society reverting back to experiential spending, such as travel and dining out, will likely negatively impact demand for many goods. Whereas, spending on services should continue to benefit from the post-Pandemic normalization of lifestyles. It is important to remember than some services businesses are still emerging from an unimaginably deep recession hefted upon them by Covid-related restrictions. An extreme example is international travel which nearly dried up to zero at one point in 2020 but now with the removal of vaccine passports and testing requirements is re-opening global tourism. Taken all together, we believe that the labor market will soften a bit from current record levels as will consumer spending, but we are not willing to throw in the towel on the entire economy just yet.
Furthermore, we believe that inflation has peaked, and this will take a significant amount of pressure off the consumer and could even be cause for a bit more optimism. Guiding this view is the simple notion that the $1.9 trillion of fiscal stimulus dollars dropped onto the economy drove excess demand and therefore inflation. As the associated spending recedes so too will the associated inflation – we are already beginning to see dramatic discounts for patio furniture, TVs, washers/dryers and so on. So long as the labor market remains strong, this retrenchment from abnormal spending levels should not lead to a recession.
Conclusion
Remain calm. Stay patient. Maintaining a defensive portfolio posture is still the most sensible stance. Bear markets are notorious for short-burst rallies that can fool investors into taking too much risk too soon. One must remain vigilant and be careful where one adds risk to a portfolio. There is no grand signal investors can look to for the “All Clear” declaration to take on more risk, however, this upcoming earnings season may be loaded with forward looking statements that could provide important clues to the market’s path forward.
Disclosures
INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.
THIS MATERIAL REPRESENTS AN ASSESSSMENT OF THE MARKET AND ECONOMIC ENVIRONMENT AT A SPECIFIC POINT IN TIME AND IS NOT INTENDED TO BE A FORECAST OF FUTURE EVENTS, OR A GUARANTEE OF FUTURE RESULTS. FORWARD-LOOKING STATEMTNS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES. ACTUAL RESULTS, PERFORMANCE, OR ACHIEVEMENTS MAY DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED. INFORMATION IS BASED ON DATA GATHERED FROM WHAT WE BELIEVE ARE RELIABLE SOURCES, AND BLOOMBERG IS THE SOURCE OF MARKET DATA. IT IS NOT GUARANTEED AS TO ACCURACY, DOES NOT PURPORT TO BE COMPLETE AND IS NOT INTENDED TO BE USED AS A PRIMARY BASIS FOR INVESTMEN DECISIONS. IT SHOULD ALSO NOT BE CONSTRUED AS ADVICE MEETING THE PARTICULAR INVESTMENT NEEDS OF ANY INVESTOR. INVESTMENTS INVOLVE RISK AND ARE NOT GUARANTEED. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS
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