Recession: To Be Or Not To Be

1740 words – a 5 minute read.

From quoting Emerson in last week’s title to Shakespeare today – down now 7 weeks in a row, blood in the streets, it’s that kind of market. The recession question does seem like the question of the day – after months of near slavish fixation on inflation, the focus has shifted to the growth side. In our topsy turvy world it makes sense that the speed of this redirection should be very fast. From transitory inflation to anticipatory recession, from real economy inflation to asset deflation.

One can see the shift in the cross asset price action as all of a sudden bonds, which have been on a relentless selloff since year end, have calmed with both the short and long end pulling back from recent rate highs. Inflation expectations have come way down as we noted last week as have break evens. It makes sense right – if one is worried about growth then it makes sense to become more sanguine about inflation.

We have been discussing the pitched battle between the two camps of inflationistas and growth bears and its pretty clear that growth bears have taken the upper hand as the bullwhip effect, discussed back in the early days of supply chain snarl, lashes the US retail sector resulting in some ugly company specific and sector specific price action. Last weekend’s twin barrel recession/stagflation warning from the B& B boys: Bernanke and Blankfein, set the tone.

Its just like this tricky market to herd all into the “defensive sectors” like Consumer Staples etc. and then unload on it with Staples down 6% in a day earlier this week… so much for safety. This selloff occurred as Consumer Staples and IT trade at the same forward PE multiple. The CS selloff does suggest that this correction/cyclical bear market has ranged far & wide across the entire equity market.

It also suggests that there should be some opportunity in identifying those companies that are able to navigate through the tricky times vs those that don’t. The old Buffett saying: when the tide goes out one can see who is swimming naked comes to mind here, suggesting that the old saw applies to both investors and companies.

With growth fears ascendant, it is worth recalling that in the various company reports the problem was not demand related – in fact both Walmart & Target spoke of solid consumer demand extending into Q2, something supported by April’s BTE retail sales report. The issues were supply chain and energy price shock related. These are issues companies can clean up as underlying conditions stabilize. 

Supply chain issues are easing with Shanghai’s main port reporting 90% thruput while the port of Los Angeles notes its ship backlog has been reduced by 50% since November. Energy prices have been rising especially on the distillate side as Brent remains close to 20% below its March highs. The issue is in diesel and gasoline prices and here too the issue is the unforeseen and pretty unforeseeable Russian invasion of the Ukraine. 

While the coming weeks should see diesel prices ease according to energy research firm Vortexa, gasoline prices continue to set US records as we approach peak driving season. This is one of the issues the growth bears note as being a negative for growth though the current driving mileage totals have hit records in past weeks suggesting consumers can stomach the price hit as total spending on food/energy remains well below prior peaks.

A lot of the growth bears worry about asset wealth destruction pointing to fall offs in stock and bond prices and the incipient rollover in housing. The point is clear but its important to remember that US house, stock and bond prices have been going up for years. The Home Depot CEO made this point in his earnings call noting that US house prices are up 40% in two years. In addition, recent mortgages have been fixed as ARMs died with the 2008 housing bust.

Consumers remain in very good shape, corporate balance sheets have trillions in cash on hand, state/city governments have rarely seen such surpluses, the credit dog has still not barked, banks are in great shape. While consumer sentiment is very weak reflecting inflation concerns, spending remains strong. This list suggests a melt down scenario akin to 2000 or 2008 is unlikely which has big ramifications.

Our view remains the “middle path” with inflation rolling over as energy price stabilize due to an energy market modus operandi being worked out in Europe which reduces risk of further price spikes; housing prices cool as the Fed’s jawboning impacts the mortgage rate side and the labor market softens as companies come to grips with the new normal of limited Covid impact, regional supply chain integration, the cap ex boom and climate mitigation we have spoken of many times.

This new normal encompasses slowing but not slow growth this year as we have highlighted for many months: roughly 3% in the US, between 2.5-3% in Europe, same in Japan and roughly 4-5% in China. All these with exception of China are WELL above pre Covid trend growth rates. Add in US inflation ebbing to 4% as we exit the year (consensus now 6% - too high) and we are talking about 6-8% nominal growth in the US and Europe.

The Fed is locked in for two 50 bp hikes over the next two months – investors appreciate the clarity and are in agreement – the Fall will be the Fed’s time to assess how its jawboning and rate hiking has impacted both growth and inflation.  Powell was very clear this week: “What we need to see is inflation coming down in a clear and convincing way”; we expect he will see exactly that this Fall, reducing the risk of a Fed policy mistake that could lead to recession.

Should recession be averted it will have big implications for asset allocation, especially on the equity side. The history is clear – non recession cyclical bears tend to include a 20% correction over 4 months or so – in other words pretty much where we are now. A bear market & recession tends to be a 35-40% drawdown over a much longer period, something one would clearly want to avoid.

Thus the die is getting close to being cast for folks like us at TPW Advisory who have remained constructive in our broadly diversified Global Multi Asset (GMA) Model. Technical levels, very important in current market conditions, suggests 3800 is a key SPY support level (Fibonacci) with the next big support down around 3200 - that’s the non recession – recession pricing impact in a nutshell.

Earnings remain robust, revisions continue to turn up in the US and Europe, companies have pricing power to support margins, derating has been significant with SPY multiple down about 30% to levels not seen in a decade while Europe, Japan, EM trade at multi decade valuations lows. EU equity trades at 12x forward EPS, roughly 20% below its 10 yr. av valuation & is back to 2007 levels. 

As week 7 of down markets approaches one challenge has been the inability to work higher as supply seems to come out whenever markets, be it Nasdaq or the SPY, try to bounce. The good news is that we have discounted inflation risk and are in process of discounting recession risk – JPM thinks US and EU equity markets have priced in 70% probability of recession.

As we see it, the set up suggests easing supply chain concerns & roughly stable energy prices as the EU outlook has improved significantly while refiners are being paid record amounts to refine. Up 6 weeks in a row and approaching levels last seen in 2002, the USD could be rolling over just as “King Dollar” starts to trend in FinTwit… that will help non US equity markets which, its worth noting, are sharply outperforming US equity of late. ACWX for example, is down 6% over the past month vs SPY down 12%; ytd, ACWX is down 14% vs US down 17%. A transition in global equity leadership from US to non US markets is a key theme; we remain OW the non US equity markets.

It's also worth noting how the thematic space is starting to stabilize, something we note via our TPW 20, 100% thematic Model. ARKK is the thematic poster child and it appears to be trying to make a bottom. The huge amount of lazy rhetoric about how “expensive “ ARKK’s portfolio is is belied by some recent FinTwit work noting that the top 25 ARKK holding now trade at an average P/S multiple of 6.3x vs 8.3x in March 2020, thus a near 25% discount to Covid lows.  ARKK is up over 4% the past two weeks while the QQQs and SPY are down over 2%. Worth paying attention to.

As we have highlighted, the ability to skirt recession opens the door to the medium term, above trend growth path we envision, driven by a cap ex boom to offset our 3Cs: Covid, Climate & Conflict and levered by a productivity surge. In this environment the fast growing thematic names should do very well.

This is a global growth path we envision and note that the EC’s recent decision to extend the pause on Europe’s fiscal stability rules through the end of 2023 also serves to open the door to a similar environment in Europe, one with more fiscal support than in the US thanks to the Next Gen program as well as all the spending to come on energy and defense security.

Asia has similar potential with Japan providing fiscal support and a very cheap FX (as does Europe by the way) and China finally enacting actual policy measures (today’s property rate cut) to support growth. A bottom in Chinese property as China’s credit impulse turns up would provide further support to global growth. April’s very weak economic data has been well absorbed by Chinese equity – another good sign.

Should inflation ease while growth stabilizes the Fed may have room to pause as we enter Fall; markets are likely to sniff that out early and react accordingly. It remains a tricky time; being balanced in one’s approach is key to making it thru with one’s portfolio intact. We are here at TPW Advisory to assist in any way we can. Please reach out.