JULY 2022

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US Equities – Pricing in a “job-ful” recession

The S&P 500 is down slightly more than 20% from the record high it hit in early Jan. According to the most widely accepted definition of a bear market, means US stocks are in a bear market now. Last month, we suggested that investors add meaningfully to their US stock portfolios if we hit bear markets levels. We are sticking with that recommendation.

Bear markets end when the market sets a new high. Historically, that does not take too long. There have been 11 bear markets since World War II. According to the Wells Fargo Investment Institute, the average bear market lasted 16 months. Since this bear market will likely be coupled with an economic recession, we should expect it to take longer than average to recover. The Wells Fargo data show that bear markets during a recession last around 20 months. Nevertheless, if history is any guide, an investor who buys today can reasonably expect the S&P 500 to be 20% higher in less than two years. That is a solid return. It is high enough to justify putting up with some potentially nasty volatility.

Last month, we pointed out that US stocks are no longer expensive. The S&P 500 is trading at around 15.8x 12-month forward earnings. According to Factset, it is below the five-year average of 18.6x, the 10-year average of 16.9x, and the 25-year average (16.5x). Even considering that current earnings estimates may be too optimistic, and not yet reflect the impact on earnings of an economic slowdown, we view US equities as attractive relative to interest rates. Price-to-earnings ratios may just be average, but average looks good compared to a 10-year Treasury yield of around 3% or less.

For the greater part of this year, investors were concerned that the US Federal Reserve would need to raise rates sky-high in order to bring down inflation. There were worries that the plans for monetary tightening by the Fed were too cautious. The most bearish voices on Wall Street feared that interest rates would need to be hiked so high in order to quell inflation, the US economy would be crushed and share prices would collapse. We did not agree with that view. We suggested last month that the rate hikes and balance sheet reduction plan that Fed policymakers had already indicated were sufficient to get inflation under control. We wrote in our June Wealth Monthly that fixed income markets had reached a state of equilibrium.

We were wrong about fixed-income markets having reached a state of equilibrium, but not wrong in the way that we feared. Fed fund futures moved sharply over the last month, but they did not start indicating that the Fed will need to get more aggressive. On the contrary, Fed fund futures now indicate that rate hike plans are going to be scaled back. Rate hikes will be wound up in the first half of next year. By the second half of 2023, the Fed is going to be cutting interest rates. Consequently, after surging to 3.5% during June, the 10-year US Treasury yield has dropped back down below 3%. As we wrote above, we believe US equities are attractive compared to government bonds.

However, lower Treasury yields and expectations of Fed rate cuts next year signal a new concern for investors. Recession fears are now the dominant market driver. The US economy is probably already in a recession. The Atlanta Fed’s GDPNow measure indicates that 2Q output contracted by 1.2%. Coupled with the 1Q’s decline of 1.6%, that fits the technical definition of recession. The question is not whether the US is going to have a recession, the question is how severe?

The S&P 500 is already down 20% from its high. We believe that US stocks have already priced in a modest recession. However, there is the possibility that the US is going to have a severe recession. If that’s the case, we could easily see the S&P 500 dropped another 10% or even 15%. The same study from the Wells Fargo Investment Institute that said that the average recovery from a bear market took 16 months, also said the average bear market decline was 35%.

Although we cannot completely rule out the possibility, we do not believe the US is headed for a terrible recession. It seems incongruous with the present tight US jobs market. The latest “JOLTS” report from the US Labor Department showed there were 11.3m job openings in May. Meanwhile, only 5.95m people were counted as unemployed, leaving 1.9 openings per every available worker, near historical highs.