Markets rebound despite the ongoing recession obsession
While recession fears dominate headlines, the stock market continues to rally – but is it sustainable?
Our Top Market Takeaways for August 5, 2022
Market Update: Recession obsession
Google Trends suggests that this summer, people are searching for “recession” more often than they did even during the spring of 2020 and the Global Financial Crisis. The Treasury market seems to be reflecting recession fears. Despite a rise in yields this week, the yield curve remains inverted with the 2-year yield roughly 40bps higher than the 10-year yield.
The stock market doesn’t seem too fussed, though. Through Thursday, the S&P 500 was continuing its rally and is now about +13% higher than its June 16 bear market low. Tech-y index stalwarts like Apple, Amazon, and Microsoft have led the pack, helping the NASDAQ-100 finish Thursday at its highest level since early May.
As we mused in last week’s note, the simultaneous recession obsession and risk asset rally may seem like a head scratcher at first…but this week wasn’t without new reasons to be more hopeful about the path ahead.
Freddie Mac’s survey of home lenders showed that national average 30-year mortgage rates fell to 4.99%, down -31bps versus last week and -82bps versus the high at the end of June. Barrels of WTI crude oil are back below $90 for the first time since the invasion of Ukraine, helping coax the national average cost at the gasoline pump down to about $4.14/gallon versus over $5/gallon in mid-June. The labor market remains remarkably resilient, with Friday’s employment data showing that the economy added 528k jobs in July – more than double the number expected.
On the other hand, the strong jobs report also showed a pickup in wage growth on the month (to 0.5%, up from 0.4% in June), reminding investors that some inflationary pressures remain stubbornly strong. To boot, we still expect more signs of a broadening economic slowdown from here.
That said, maybe we’re at the point where investors en masse have accepted inflation and growth risks and are starting to look beyond the slump. Or, maybe the recent rally is nothing more than a FOMO-fueled false start.
Spotlight: Bear market rally or bottom?
While the +13% midsummer stock market rally from the lows has been a welcome reprieve, we caution investors not to let their guards down. The definition of a “bear market rally” is nebulous, but for comparison to today’s price action, we’ve decided historical instances should meet all of the following criteria:
- Must follow a drawdown of at least 20% from the market’s previous all-time high.
- Must be a gain of 10% or more from the bear market’s prior low.
- Must be followed by another decline that represents a new low for the selloff (i.e., not be the first leg in the market’s recovery back to all-time highs).
According to those parameters, we found that five of the six major selloffs since the ‘70s had at least one relief rally of more than 10% before dropping again to make fresh lows (2020’s lightning-quick selloff was the exception). The Global Financial Crisis and Tech Bubble each had three; the late ‘80s bear market – which was not accompanied by a recession – had one.
The point is, intra-selloff rallies can and have happened. While we’re not insisting that the S&P 500 will have to retest the 3,666 lows hit in June, we’re not convinced that a sustainable upside path for stocks has gotten any easier at the current juncture. Inflation is still untenably high, the Fed is keeping its policy options open, and earnings expectations just started getting revised lower.
The high yield bond market is telling a similar story. Over the past month, credit spreads have tightened by more than 100bps amid the risk-on shift. That said, over the past six months, new issuance of high yield bonds has slowed to ~1% of the overall market size. Since the Global Financial Crisis, past instances of issuance this light typically foretold a swing higher in defaults (the median one-year forward default rate was 4.2%; two-years forward it was 8.6%).
With defaults still below 1% today, we read that as a signal that credit spreads are likely to widen from here – even if we manage to avoid recession.
Whether historical bear markets were ultimately associated with a U.S. recession may not offer conclusive evidence about the durability of a rally off the lows, but it has seemed to have implications for both the magnitude of the market selloff at its worst and the duration of the slump.
Before this one, we’ve seen a total of 12 bear markets since the end of World War II, nine of which occurred around recessions. The recession bear markets saw an average decline of -36% and peak-to-recovery duration of roughly three and half years. That contrasts to non-recession bear markets’ average peak-to-trough decline of -28% and duration of about one and a half years.
If a recession does come to fruition, we think it is likely to be less severe than those in recent memory given strong consumer and corporate balance sheets and a still-resilient labor market. Regardless, the probability of a U.S. recession occurring in the next year – even if a mild one – is admittedly tough to handicap right now. Rough odds, we would call it a coin flip.
Investment Implications: Conviction is a rare commodity
The bottom line: The macroeconomic backdrop is still rife with uncertainty, and the potential for risk assets to re-test their prior lows leaves us with a preference for more defensive exposures. This rally may be a good opportunity to reposition into less risky exposures, some of which may now offer potential returns sufficient enough to stay on track towards financial goals.
For example, earlier this week, our Chief Investment Office trimmed equity overweights in exchange for more exposure to core bond duration in the multi-asset portfolios they manage. Still, we think a modest equity overweight is warranted, given that today’s economic conditions and markets are moving faster than what is historically typical. In our view, the stock market is likely to be higher than it is today one to two years from now, even in the event of recession.
Beyond core portfolios, we’re still seeing tactical opportunities, like putting volatility on our side to add equity exposure with downside protection via structured notes. For more opportunistic investors keen on leaning into risk, we think asset classes like preferreds and hybrids may be a good first step to do so right now.
Conviction may be a rare commodity in today’s investment environment, but we have it when it comes to our recommendations on portfolio positioning.
All market data from Bloomberg Finance L.P., 8/4/22.