Markets are not the economy

• At this point, inflation has simply stayed too high for too long. We’ve officially moved our probability of a U.S. recession to 45% within the next 12 months. Consider that a coin toss.
• Even if you knew a recession was happening, when you extend the time horizon out to even just one year, the prospective S&P 500 return following initial -20% drawdowns becomes compelling.
• All in all, we think it is becoming increasingly important for investors to understand the difference between the economy and the market. If the Q2 GDP print happens to be negative, we’ll get the inevitable headlines declaring the U.S. is in a “technical recession.” We want to get ahead of that, because if history is any guide, that might be just the perfect time to buy.

We all knew inflation was going to be higher after the onset of COVID: It turns out that it’s tough to pump trillions of dollars of stimulus into an economy, simultaneously deal with supply chain issues, and avoid an increase in prices across many different goods and services. But we, and many other market participants, have underestimated the persistence of inflation into 2022. The normalization we expected in both supply and demand has not ensued. It’s been caused by a variety of factors, including the war in Ukraine and China’s zero-COVID policy, which have both continued to distort supply. But at this point, inflation has simply stayed too high for too long.

It has now reached a point where it has forced the Federal Reserve’s (the Fed) hand. They need to restrict economic activity to slow rising prices. The Fed can do this most directly by hiking interest rates: So far this year, the Fed has hiked the Fed Funds rate by 1.5% and is expected to get to over 3.5% by year-end¹. This hiking should begin to tame inflation by making borrowing costs higher, but this will come at the cost of slowing economic conditions. How much it will slow the economy is up for debate, but the longer that inflation runs hot, the risks of recession increase: We’ve officially moved our probability of a U.S. recession to 45% within the next 12 months. Consider that a coin toss.

That may sound scary, and we’ll no doubt continue to see news headlines and hoopla about “recession” and what that means for consumers and businesses. But as you consider the implications of higher recession risk for your long-term portfolio, it’s important to remember that the economy is not the same as the equity market. We invest in stocks, not GDP.

The stock market almost always bottoms well before a recession is over, and, sometimes, before we even know that we’re in a recession. It should work like that. Equity markets are publicly-traded 252 days a year. They are the best forward-looking mechanism for economic growth and earnings that we know of. GDP by definition is a backward-looking growth number, measuring the last 12 months or last quarter of economic output. It tells us what has happened, not what is going to happen in the future.

The equity market – as measured by the S&P 500 – has already drawn down -20% from its high¹ . If you were going to cut equity risk, the ideal time to do that was in January. But at this point, the market knows recession risk is elevated – you typically don’t get 20% sell-offs unless that’s the case. As such, we think the time to trim equities tactically has passed. It’s like paying a professional athlete: You don’t give them the massive contract after they’ve had a great career when they’re nearing retirement (unless you’re the Yankees). You pay them when they’re younger and still in their prime (just ask 26-year old Pat Mahomes and his $500mm+ contract).

Michael Cembalest, our Chairman of Market and Investment Strategy, showed the relationship between equities and GDP during recessions in his latest Eye on the Market. We also pulled some data for a wider set of recessions dating back to 1957. If we exclude 2001 (which was the one instance when the market bottomed after the recession was over) on average, the S&P 500 bottoms three months after a recession starts but 10 months before the recession ends. Other than 2001, all market bottoms since 1957 occurred before the recession or while the recession was still ongoing² .

So if we do end up having a recession, the more interesting question becomes, how bad will the total drawdown be? The chart below shows the past seven recessions where there was at least a -20% drawdown in the S&P 500. If we knew with 100% certainty that there was going to be a recession, on average, history suggest another -20% down in equities from here. But not all recessions are created equal. There’s been a big difference between the experiences in a mild recession vs. “crises.” Instances like stagflation in the ‘70s or the GFC saw markets draw down another -30%+, even after the initial -20% drawdown. But if it’s a more mild recession, like the early ‘80s or early ‘90s, the numbers would suggest we could be within spitting distance of the bottom. 

No one knows for sure what will happen, and we have to acknowledge that a deeper recession is a risk – as it always is in an economic slowdown: If inflation stays red hot despite the Fed tightening, then a larger recession could happen. But several data points suggest that won’t be the case this time. One important aspect is that consumer and corporate leverage is nowhere near levels seen in past crises – like the Global Financial Crisis – and leverage levels are even below where they were pre-COVID. Additionally, wage growth has already started to slow meaningfully, suggesting a wage-price-spiral like the ‘70s – where higher wages created higher consumer demand and perpetuated higher prices – is unlikely.  

Corporate Debt service costs at multi-decade lows³

U.S. non-financial business interest expense as % of revenues

WAGES COULD BE DECELERATING WITH MORE LABOR SUPPLY⁴

Average hourly earnings by income group: % year-over-year change

Perhaps most importantly, even if you knew a recession was happening, when you extend the time horizon out to even just one year, the prospective S&P 500 return following initial -20% drawdowns becomes compelling. The chart below shows average one-year return following the initial -20% drawdown in recessions was +7%, albeit with a lot of disparity. But when you extend to three years, the numbers get more compelling, with 2001 being the only instance where you lost money (-3%). And remember, these are seven instances where a recession actually happened. Recession is not a guarantee today.

Within our managed portfolios, with most of the mild recession risk already priced into markets, our Chief Investment Office Team (“CIO Team”) – who manages over $250 Billion of multi-asset strategies – has an overweight to stocks vs. bonds. And if we get another leg down, the team’s bias is to increase the overweight.

In looking at our broader managed portfolio platform, we’re also starting to see the first signs that investors are becoming more comfortable with the mild recession view, where inflation moderates as the economy weakens. Growth equities and duration are the most sensitive to the potential more severe recession because bond yields would continue to rise in the near-term ahead of that. Over the past few weeks, the market activity suggests a lower probability of that occurring (weaker commodity prices, UMich inflation expectations revised down), and we’ve noticed a bounce back in the higher-growth strategies as long-term bond yields moved lower.

We’re not trying to call a bottom in growth vs. value. But if inflation does start to materially slow, higher-growth strategies could get the biggest near-term boost. We continue to recommend a balance between growth and “non-growth” strategies. We like high-quality value strategies here…but we don’t think you should completely abandon your growth strategies either. Something like a 50/50 split feels right. A core strategy will do that for you, too.

As the yield curve has flattened, longer-duration fixed income strategies have also rallied more than their shorter-duration counterparts. If inflation comes down, expect this to continue, even more so if we enter a recession. We continue to like duration. Our CIO Team has added duration five separate times in fixed income portfolios this year.

All in all, we think it is becoming increasingly important for investors to understand the difference between the economy and the market. If the Q2 GDP print happens to be negative, we’ll get the inevitable headlines declaring the U.S. is in a “technical recession.” We want to get ahead of that, because if history is any guide, that might be just the perfect time to buy.