Trending globally: Lower profits, economic recessions
Reading equity markets research and strategy reports from around the world, two trends have clearly emerged in recent weeks:
- a growing acceptance/belief the US economy might be in recession later this year or next (ignore the statistical aberrations for Q1 and Q2 this year) Tthere seems very little doubt the UK and Europe will have their recessions, and so will various emerging economies, with Australia suffering a severe slow-down.
- a conviction that current market forecasts for corporate margins and profits are too high for the year(s) ahead, and a sizeable adjustment downwards is to be expected.
Views and predictions around inflation remain as wide and diverse as they've been post-pandemic. This has not changed after yet another US CPI upside surprise.
Below is a selection of views collected over the weeks past.
History is no guide, says BoA
Bank of America Securities' chief investment strategist Michael Hartnett put it as follows when the June results of the global fund manager survey were released in the middle of June:
"…history is no guide to future performance but if it were, today's bear market would end on Oct 19th 2022 with the S&P 500 at 3000".
"Take your heads out of the sand" warns Albert Edwards
Societe Generale's Albert Edwards became an instant celebrity during the bear market of 2008/09 when his index projections first looked ridiculous, then eerily accurate.
But fame in global finance doesn't stick. Not when the next decade turns into a raging bull market and you're still doing your utmost best to highlight and emphasise the potential negatives.
And that, we should all realise, is Edwards' job at Societe Generale. His often outlandish views do not correspond with his employer's official prognosis - Edwards is specifically employed to offer the 'what if' scenarios, as in: what if the world goes pear-shaped in the year ahead?
That said, Edwards has been reflecting back on the 2008-experience of late, and more specifically how energy and mining stocks held up back then, while the rest of markets got shredded into little pieces, until both sectors too had to give in to the gravity-pull of the GFC bear market.
So far, Edwards observes, 2022 is pretty much following the same scenario, with small differences in timing. His conviction thus remains undeterred:
"Soft-landing advocates must now face the overwhelming evidence of economic collapse and extricate their heads from the sand."
The Ukraine war is keeping oil prices elevated for longer, but Edwards predicts it won't change the broader picture in that oil prices too will eventually respond to the severe recession that is coming. His key surprise has been in weakening agricultural commodities. But then again, this simply feeds into his view that energy prices cannot stay where they are.
The Big Surprise over the next six months, Edwards predicts, will be a collapse in global CPI surveys as commodities deflate and a deep recession announces itself. Get prepared for 10-year bond yields returning below 1% is his credo.
"...a cyclical bust awaits and that will feel very much like a full-blown return to deflation."
The simplest of warnings here is that, back in 2008, just about everyone smiled (if not laughed) when hearing about Edwards' predictions early in the year. But six months down the track, a general sense of awe had overtaken the initial ridicule.
Was 2008 the one lucky gambit or will 2022 cement Edwards as the one to turn to during bear markets?
The answer, as Bob once sang, is still blowing in the wind...
The "everything bubble" has now burst
Societe Generale's Albert Edwards is not, however, the most bearish of market commentators this year. He's in a very tight contest for that title with the team of strategists at Saxo Bank where the ruling view is the Everything-in-a-Bubble has now well and truly burst.
Our best guess, posits the team, is the S&P500 will ultimately correct some -35% from its peak while the market finding its bottom could take as long as the middle of next year.
"The V-shape recovery will not happen this time and the bear market will likely not exhaust itself until the new generation of investors that went all-in on speculative growth stocks, Ark Invest funds, Tesla and cryptocurrencies have fully capitulated."
Saxo is preparing for inflation to remain structurally high, for yet another crisis in Europe, as the world of crypto-assets is facing a Big Clean Up, likely resulting in much stricter regulation (than otherwise would have occurred), while a come-back for fossil fuels is sending clean energy commodities "off the rails".
Industrial commodities will go into hibernation, to be awoken again later on as the global economy is facing an L-shaped recovery trajectory. Saxo refers to prior bear markets of 1970s, 2000 and 2007 and the fact after each of those, economies took around four years to recover.
Saxo says companies to own this time around are energy producers and quality industrials that pay a dividend, with strong earnings and cash flows to sustain those dividends while fending off the pressure from higher rates, wage inflation and additional inflationary pressures.
The key conclusion to draw from Saxo Bank versus Edwards is there can be multiple scenarios to potentially push this year's bear market onto much lower levels.
"A counter-movement inside a downtrend"
Shifting towards the here and now on equity markets, David Rosenberg of Rosenberg Research remains steadfast in his view that what is occurring in July is simply a short-term relief rally/bounce from heavily oversold conditions.
Best to leave this uptrend to shorter-term traders, suggests Rosenberg, as investors should treat it as a counter-movement inside an overall downtrend.
Rosenberg continues to preach investment portfolios should be conservative and defensive with the Federal Reserve over-estimating real strength in the US economy. Soon Powel & Co will be forced to pause in their tightening process, albeit it will be too late to avoid a recession, remains Rosenberg's view.
Inflation will be replaced by another period of deflation, with much lower bond yields, if Rosenberg's predictions prove correct.
Toohey's line in the sand
Tim Toohey, Yarra Capital Management's head of macro and strategy, offers a glimpse of optimism in that he still anticipates a challenging third quarter for equity markets this year, but Q4 might bring along the "line in the sand" when equities might enjoy the early beginnings of a genuine rebound.
Toohey's time schedule is based upon a number of assumptions:
- The Fed will stop tightening around September as economic data deteriorate
- Falling commodity prices and bloated inventories will soon have US inflation starting to surprise to the downside
- The RBA too will complete its tightening cycle before year-end, at around 2.35% and while Australia should avoid a recession, growth next year will be scant.
The silver lining for markets, suggests Toohey, is that interest rates will likely be lower than what the bond market is currently pricing.
"September-October should be the time to re-enter and take advantage of some relatively indiscriminate selling in quality equity names."
"Forecasts are too high"
Strategists at UBS remain steadfast in their prediction that earnings forecasts are not only too high, but the process of re-adjustment to a much tougher environment will also last until (at least) February next year.
Meanwhile, investors are advised to take a much more defensive stance with UBS guiding towards companies that should outperform in times when inflation is high and interest rates rising, while the growth outlook is decelerating.
The degree of prior excess will determine the outlook
A warning from MFS Portfolio Manager and Global Investment Strategist, Robert M. Almeida, Jr.; while it has become popular by today's Finance Commentariat to predict future outcomes through historic parallels and averages (the average bear market lasts, the average return from the bottom, etc), ultimately it is the degree of prior excess that will determine the outlook for today's equity markets.
"The length of the business cycle is irrelevant. What matters is the level of excess and the magnitude of the needed rebalancing process. That determines how much further we may still have to fall."
Almeida is worried about corporate margins in the face of obvious revenue and cost input pressures.
"Companies are telling investors they can maintain historically high profit margins despite rising recession risks and rapidly rising costs. History suggests otherwise."
A few snippets from a recent report by Morgan Stanley
- equity markets tend to bottom on average 2-3 weeks before the consensus earnings revision ratio troughs;
- the average time taken between the date of the first move into negative earnings revisions and the trough in revisions (i.e. maximum downgrades) is 7-8 months;
- the quickest transition recorded thus far still required approximately 3 months.
"Given that earnings revisions for MSCI Europe currently remain positive, this timetable would imply that we are still a few months away from a likely bottom in equity indices."
I'd argue what applies to Europe, equally applies to Australia and the USA.
T Rowe Price remains cautious
"While equity valuations are more reasonable after recent declines, we remain cautious on the earnings growth outlook and inflationary impacts on margins supporting our modest underweight. Within fixed income, we remain underweight bonds and overweight cash."
"Within stocks, we closed our position in REITs due to higher yields and our inflation outlook. This allowed us to further narrow our value vs growth overweight position by adding to our growth equity portfolio where valuations partly normalised."
"…growth could be due for a spurt higher as many of the tailwinds for value—higher energy prices and rates—may be peaking."
"We think it is better to prepare for slowing growth and rising recession risk in 2023 rather than dwell on what stares us in the face today (higher inflation)."
"We have increased our exposure to defensive growth, such as consumer staples and health care, funded from the more cyclical parts of the market."
"We believe that we are only in the early stages of a global earnings downgrade cycle, which is expected to intensify as recession fears increase."
The difference lies in your perspective (and age), says Zweig
"For people still in their prime earning years, this bear market is likely to be as bullish in the long run as it is painful in the short run. For older investors, the decline is potentially devastating."
Jason Zweig in the Wall Street Journal.
Nomura: "Policymakers' hands are tied"
Japanese powerhouse Nomura is now also forecasting a mild recession for the US economy, starting in the final quarter of 2022. Nomura has cut its 2022 US GDP forecast to 1.8% growth from a prior 2.5%, and 2023 to a -1.0% decline from a prior 1.3% growth forecast.
"Relative to previous downturns, the significant strength of consumer balance sheets and excess savings should mitigate the speed of the initial contraction. However, policymakers’ hands are tied by persistently high inflation, limiting any initial support from monetary or fiscal stimulus."
The not-so-great news is inflation is projected to remain elevated, which means the Federal Reserve has to stay on its current course for longer too. Hence, Nomura is expecting ongoing rate hikes into 2023 but from February onwards the momentum should change. Not long after, Nomura expects by the second half of next year, the Fed will start cutting rates again.
Equally important: Nomura sees more downside risks emanating from business debt than from consumer debt. As Republicans are expected to grab the majority in both parliamentary houses next year, Washington gridlock will be back, possibly exacerbating the economic recession.
US Treasuries are projected to invert - 2-year versus 10-year - in Q3 and remain inverted for the next 12 months (!). As bonds will respond to the increased spectre of recession, Nomura has lowered its year-end projections for the yield on the 10-year bond, to 2.65% for end-2022 (was 3.10%) and to 1.70% (was 3.05%) for end-2023.
In terms of the trajectory of Fed tightening, Nomura has pencilled in another 75bp hike in July, followed by 50bp in September, then 25bp in each meeting in November and December. This lifts the policy rate to 3.25%-3.50% by year-end. At the meeting in February, the Fed is projected to deliver its final hike (25bp) in this cycle.
By September next year, all Fed meeting announcements are expected to involve rate cuts.
Canaccord sees inflation slowing
It's probably a sign of the general caution that has crept into the financial community's mindset when both authors of an optimistic share market review, albeit from a technical analysis perspective, go out of their way to not seem too positive about the market's outlook.
And so it is that the July strategy update for US equities by Canaccord Genuity expresses the belief that "a bottom" might be in for US markets, but it might not be "the bottom".
For what it is worth, "a bottom" traditionally stems from too negative sentiment (oversold conditions) while the authors suggest it will require a change from the Federal Reserve for investors to look through the upcoming weakness in the economy and corporate profits before US markets can rally from "the bottom" during this year's bear market.
Alas, Canaccord sees inflation decelerating, but also remaining at a level too high during the second half of 2022, which means the Federal Reserve will stay in tightening mode, irrespective of the slowdown in global economic growth.
Real liquidity, as measured by Canaccord through M2 money growth plus equity and bond mutual funds and ETFs, minus industrial production growth rates, has now dropped to a level that historically has been associated with an economic recession, points out the July strategy report.
Going all the way back to the 1970s, today's reading has never been as far into negative territory as... during the 1970s.
More upside ahead soon?
Another trend that's worth mentioning is this: short-term optimism that share markets, at least for now, might be poised for more relief and further potential upside
All trends mentioned have been combined in Longview Economics' recent strategy update in which Chief Market Strategist Chris Watling expresses his optimism for global equities on a 1-4 months timeframe.
That optimism, it turns out, is based on Longview's in-house technical modelling, as well as on the observation that lower prices for energy and commodities should be a positive for technology stocks and the broader outlook for inflation and economies.
In addition, the technology sector has just experienced its worst de-rating in 40 years, which, history suggests, should feed into at least a prolonged recovery rally, if not a fresh bull market, argues Watling.
The bad news stretches beyond the current rally for equity markets, as Longview has now joined the experts who believe an economic recession has pretty much become unavoidable.
Like so many other sophisticated market analysts, Watling is paying close attention to global liquidity, which seems to have peaked in April and the money supply is since contracting rather rapidly.
On the current trajectory, points out Watling, and if the Fed doesn’t pivot quickly, money is becoming too tight for the US economy, at a level of growth that has historically led to recessions in the following year.
Traditionally, a reading of between 60-70 on the Longview Liquidity Indicator suggests a high risk of an economic recession in the US. The latest reading surged beyond 70.
"All of which suggests that the likelihood of a recession in 2023 is growing (and is now more likely than not, i.e. >50% probability). If correct, then as has been widely discussed, earnings for 2023 are too high (consensus is for S&P500 earnings growth of 9.1% in 2023 and 8.6% in 2024). In recessions, forward consensus earnings typically fall by between 16% and 40%."
More downward revisions are likely, says Clearbridge
"The second leg of most bear markets features earnings contraction. The current bear market has been entirely driven by P/E compression, while forward earnings expectations have risen by a healthy 7.4% this year.
"In the last two weeks, earnings revisions have started to drift lower, and we see a strong possibility of more meaningful downward revisions as we move through the back half of the year. Ultimately, the degree to which earnings expectations decline will determine the degree of the economic slowdown.
"One thing we monitor to help evaluate this dynamic is the ISM Manufacturing PMI (the ISM), which tends to lead S&P 500 earnings by six months. Historically, the ISM has fallen below 43 — a level typically consistent with double-digit earnings declines — during prior bear markets that came after Fed tightening cycles. Should this relationship hold, the market could see new lows in the coming months."
"Regardless of whether we achieve a soft landing, or if the market low has already occurred, bear markets have historically been good entry points for long-term investors.
"In previous bear markets over the past 80 years, equities have fallen a further 16% on average after breaching the 20% mark. Subsequent downside has been greatest when the bear market coincided with a recession, but equities have still fallen a further 11% on average during non-recessionary bear markets.
"The good news is that those additional losses are usually recovered quickly, with 12% upside on average in the year following a 20% decline."
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