In this comprehensive analysis, we provide an overview of the current market and economic landscape, highlighting the challenges and headwinds that lie ahead. While the prevailing sentiment suggests a bearish outlook with an imminent recession, we argue for a closer examination of various factors that present a more constructive and bullish view on risk assets. By delving into the intricacies of recessionary concerns, the inflation problem, how markets bottom, bearish theses, and liquidity considerations, we provide a well-rounded perspective on the market's trajectory.
Most data points indicate a recession is coming
The inflation problem
Equities always bottom during strong recessions
Stocks are expensive by many metrics
The most widely predicted recession in history
Valuations are in the eye of the beholder
Forward looking markets and the AI revolution
Liquidity and the Treasury General Account
The Fed is almost finished hiking
Positioning is cash heavy
Backdrop 1: Most Data Points Indicate a Recession Is Coming
There are several key concerns on the horizon that indicate the likelihood of an upcoming recession.
Moreover, several leading indicators further support the anticipation of a recession. The ISM Purchasing Managers Index, the Conference Board Leading Index, consumer expectations, the yield curve, and loans to small businesses all reflect a negative outlook. These indicators collectively suggest that an economic downturn is imminent.
The inversion of the yield curve has been ringing the alarm for a while now. This phenomenon, where the yield on longer-term bonds falls below that of shorter-term bonds, has historically been a reliable indicator of impending economic downturns. It serves as a warning sign that investors are demanding higher returns for the perceived risks associated with the future economic outlook.
Curve Inversions usually but not always precede recessions
Additionally, the banking crisis that occurred in March has heightened fears of a broader impact on the economy. The fear of this crisis spreading and causing significant disruptions in the financial sector has contributed to the prevailing sentiment that a recession is on the horizon.
Backdrop 2: The Inflation Problem
Unlike recent cycles, inflation has become a genuine concern and has exhibited resilience even in the face of the Federal Reserve's historical hawkishness. What initially was touted as driven by supply chain disruptions has permeated into various sectors, such as housing, services, wages, and tradable goods. While there are signs of inflation receding, the pace is not fast enough to warrant a Fed pause just yet.
Backdrop 3: Equities Always Bottom During Strong Recessions
Traders often believe stocks always bottom during recessions. Historically, equities bottom either around monetary policy easing or reacceleration of economic activity. And as showcased in a study by Goldman diving into the S&P 500's drawdowns of more than 15% since 1950, when the correction is driven by deleveraging, the equities bottom happens during recessions, close to the ISM bottom (i.e. reacceleration of economic activity) and long after the Fed has started to ease.
Backdrop 4: Stocks Are Expensive by Many Metrics
For example, the earnings yield of the S&P 500 (12 months forward) is now around the same levels han the yield on US corporate investment grade bonds and the rate of three-month treasuries.
Summary so far
It were to seem a recession is unavoidable, risk assets are expensive, and always bottom during deleveraging driven recessions. Guess a major crash must thus be inevitable ...
Let's Explore the Other Side of the Coin, and Debunk it All
First, On Recessions:
The upcoming recession, if any, has been the most widely predicted recession in the historyof civilization. Therefore both markets and economic actors have front-run it. Which by definition reduces the probability of it happening, and its magnitude if it does.
Economists lowered their forecasts in response, leading to one of the most important drivers of equity performance this year: the fact that economic activity has been consistently surprising to the upside. After all, markets are pricing mechanisms, and what truly matters is not if data comes in positive or negative, but if data comes in better or worse than what is priced in.
Furthermore, the view that risk assets must bottom if the US enters a recession is also flawed due to the very limited sample size of US recessions. Plenty of counterexamples exist outside of the US. Just now for example Germany's DAX index has been printing new all time highs while Germany is in recession.
Second: Valuations Are in the Eye of the Beholder
Stocks cannot be universally deemed expensive; bias in data and timeframe selection can make all the difference. There are metrics that depict fair pricing and merit closer examination, such as forward P/E for the S&P 500 ex FAANG.
Third: Markets Are Forward Looking, and the AI Revolution Is Real
The world is undergoing an AI revolution comparable to the internet evolution or the industrial revolution. Nvidia's earnings have just skyrocketed. Analysts estimate AI could replace up to 25% of current employment in developed countries, while generative AI could raise annual productivity growth by 1.5 percentage points over 10 years, and this productivity boost could eventually increase annual global GDP by 7%.
Fourth: Liquidity! Market Placing Extreme Emphasis on the TGA draining liquidity
Many analysts see the Treasury refilling the Treasury's General Account ("TGA") as a strong headwind for risk assets, akin to quantitative tightening ("QT"), whereas the Treasury issues bonds to the public, in exchange of liquidity (cash), which is thus removed from the economy.
So, TGA up, risk assets down, right? Wrong.
The importance of the TGA is exaggerated. For many reasons. Contrary to popular belief, liquidity is not the main driver of equity prices. It is all about flows, not liquidity. Positioning, rates, liquidity, growth, valuations and expectations are what drive flows. After all, liquidity is a snapshot, while prices are forward looking.
The TGA is known to be decorrelated from risk assets for very long periods of time. In fact, the four largest TGA rebuilds over the last two decades have had a minimal impact on the market.
While QT represents an asset swap that increases duration in the market (swapping long for short), TGA replenishing at present simply changes investor allocation from one cash-like instrument to another, as most issuance is in bills (short-term treasuries). Furthermore, much of the TGA refill comes from market funds rotating holdings away from the Fed’s overnight reverse repurchase facility, having therefore no impact on net liquidity.
Fifth: The Fed Is Almost Finished Hiking
The main reason for markets to crash in 2022 was the Federal Reserve's tightening cycle. The Fed has delivered 20 x 25bps rate hikes in its fastest and most aggressive hiking cycle in history, and it is likely 90% done, with the Fed talking about two more hikes ahead. Given 20 hikes already behind us, what difference would it make if the Fed were to raise three more times instead of one? The answer is simple: likely not that much.
Sixth: Positioning is Cash Heavy
Short-term speculative money positioning in equities is hot, but cash held by longer-term market participants is historically high.
According to the Investment Company Institute (ICI), money market funds hit a record $5.4 trillion on June 7th, and have remained at that level since. More interestingly, institutions (defined as banks, insurance companies, pension funds, mutual funds, and other financial organizations) are holding $3.4 trillion in money market funds as of June 28th, roughly 2% above the prior highest level on record, which happened in May 2020, the darkest point of the pandemic shock.
In conclusion, the logic that "markets must crash" due to an imminent recession and overvalued risk assets is flawed. Short-term money positioning in stocks is hot. That aside, longer term institutional money is cash heavy at the moment, the Fed is nearing the end of its tightening cycle regardless, growth has been resilient, and inflation has assumed a secondary role when it comes to market drivers. Growth and avoiding a severe recession are what matter the most. The market is currently estimating a 25% to 35% probability of a recession in the US. A market crash would require an information shock, such as significant deviations in inflation, plummeting PMI readings, adverse geopolitical developments, or a dismal earnings season for big tech companies. We see no reason at this point for changing our bullish stance on risk assets, which we've held for all of 2023.
The trend is your friend. And the trend is up.
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Macro insights | July 2023 |