Bridge over troubled water: Correction or Recession?

Rod Skellet

Mason Stevens

Recent stock market volatility and fixed income market extremes have presented equity and fixed income investors alike, with one of the most challenging and complex markets in living memory. Most commentators are in agreement, that the current market dynamic is unsustainable in the medium term and that something has to give. Are we facing a correction, which may result in some short-term pain, but will over a quarter recover and growth will continue, or will we face something worse with economic conditions spiralling into negative growth for a significant time?

By definition, a stock market correction is a fall of 10% or more for a stock or index from its most recent peak and is usually short lived with time periods averaging 3 to 4 months. While corrections can be painful in the short term, if investors are confident in their view, they can provide short term buying opportunities. The hot money is invariably shaken out of the asset class as the longer-term investor with a more rigorous investment thesis stays true to course

Recessions on the other hand are far broader in scope and is described as 2 continuous quarters of negative GDP growth. Recessions affect not only investors but the wider community, with wage growth, employment numbers and company revenues and profits all falling, resulting in sustained equity market falls. Invariably recessions last years, (2 to 5 years).

Looking at equity markets both here and in the US, we can see that the testing of recent highs indicates confidence in corporate earnings, and this is certainly been reflected in the US earning season to date which has seen more than 50% of the S&P500 companies deliver earnings that beat market analyst forecast. As the chart below indicates, the US equity market has hit record highs of 27359 on the 5th July 2019.

Source: Bloomberg
Source: Bloomberg

The Aussie market was all to similar, with the ASX 200 touching all-time highs in July 2019.

Source: Iress
Source: Iress

At present equity markets have not even triggered to correction status, with the market still trading higher than we were in early June 2019 and a solid 15% away from the lows of late December 2018.

There are no doubt unique issues driving each market with high iron ore and gold prices in Australia combined with record low interest rates and the return of the Liberal National government underpinning the equity market while in the US, low interest rates, a solid corporate earnings season and a degree of pump priming by a Twitter happy president have all contributed to a strong equity market.

In contrast, and this is the bad news, Central Banks around the world have driven rates to record lows, to the point that in the United States, 10-year Treasuries (1.67%) are trading 50 basis points inside cash (2.14). This inverted yield curve, is historically been one of the leading indicators that points to a recession. In every recession over the past 50 years, this curve has inverted.

Source: Bloomberg
Source: Bloomberg

Why have Central Banks been on an easing bias and what catalysts are on the foreseeable horizon that could push global economies into recession.

In no particular order, the following issues are weighing on investors and no doubt central bankers' minds;

  • The pending US-China trade war
  • Brexit- Deal or no Deal
  • China GDP
  • Oil supply and tensions with Iran in the Straits of Hormuz
  • Commodity prices especially Iron ore and Coal from Australia's perspective.

There is an old adage that the equity market trades on Greed and the fixed income market trades on Fear. If we take these statements literally, the fixed income markets are bracing for a pretty rough three to four years, while the equity markets seem to be looking through rose coloured glasses.

Given the equity market is 100th the size of fixed income markets and that at present 25% of all government issued debt is trading at negative nominal yields, which amounts to $14 trillion USD equivalent, the likelihood of the fixed income markets being wrong is very low.

There is a possibility that any recovery in equity markets will be short lived, more like a "dead cat bounce", so adopting a strategy of buying the dips with a view to a sustained share market rally might be optimistic. The risk of a trade war induced recession is very real, with the perception of Australia's Export and commodity-based economy at risk of being a sideline casualty. Therefore, it may be wise for equity portfolio's to be structured more on the defensive side, with companies with 10 year plus sustainable earning history and dividend growth preferred, with the preservation of capital paramount. 

Rod Skellet
Rod Skellet
Investment Strategist, Equities
Mason Stevens

With over 30 years of experience in financial markets, Rod has a strong background in both equity and debt derivative markets and equity and debt capital markets, having held positions at ASX, Ords/JP Morgan, Deutsche Bank, BITG and Origin Capital.

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