State Of The World

“The process [raising interest rates] is highly likely to involve some pain but the worse pain would be in failing to address this high inflation and allowing it to become persistent.” Jerome Powell, Chairman of the Federal Reserve System.

“The stock market rout of around 20 percent has caused around $10trillion in US household wealth to evaporate. In addition, at least $3trillion in bond and $2trillion in cryptocurrency wealth has been wiped out by the rout in those markets.” Desmond Lachman, AEI.

“There are recurring cycles, ups and downs, but the course of events is essentially the same, with small variations. It has been said that history repeats itself. This is perhaps not quite correct; it merely rhymes.” Theodor Reik, “The Unreachables” (often attributed to Mark Twain).

State Of The World

The process [raising interest rates] is highly likely to involve some pain but the worse pain would be in failing to address this high inflation and allowing it to become persistent.” Jerome Powell, Chairman of the Federal Reserve System.

The stock market rout of around 20 percent has caused around $10trillion in US household wealth to evaporate. In addition, at least $3trillion in bond and $2trillion in cryptocurrency wealth has been wiped out by the rout in those markets.” Desmond Lachman, AEI.

There are recurring cycles, ups and downs, but the course of events is essentially the same, with small variations. It has been said that history repeats itself. This is perhaps not quite correct; it merely rhymes.” Theodor Reik, “The Unreachables” (often attributed to Mark Twain).

Of the 186 quarters since 1976, a negative quarterly return for both stocks and bonds has occurred just 20 times including the second quarter of 2022. Furthermore, over the same period, there are just five instances where both stocks and bonds are negative for two consecutive quarters. Recessions have been associated with three of the previous four periods and the jury is still out on the latest instance. In the quarter following two negative return quarters for both stocks and bonds, equities were positive during three of the four instances while bonds were positive in all four. The one instance where equities continued to decline was during the [2008] financial crisis. While it’s difficult to say what will happen in the coming quarter a bounce is certainly possible.” Ryan Grabinski, Strategas Research Partners.

Ultimately, what will decide the fate of equities over the coming 12 to 18 months, will be whether we see a recession in the US and the rest of the World, if so, what type, and how corporate earnings behave. As a species, we are conditioned by what is called recency bias. This means we carry the memory of a recent traumatic event and apply the experience to what we are going through now.

When we come to look at the US facing up to a potential recession today, the spectre of 2008-2009 hangs over markets. So, it is perhaps unsurprising that investors are conditioned by that experience, which was explicitly a credit event, e.g. banks went bust. This episode led to a 57% drop in earnings for US companies at the time, driving a massive decline in the value of the S&P 500 Index. The current backdrop looks different, with the catalyst for worries now the tightening of US financial conditions, via rising interest rates, to deal with inflation.

It could, therefore, be appropriate to go back further in time, and look at the two deepest inflation related recessions in the US; firstly in 1973-1975, real (after inflation) growth fell 2%, but nominal growth rose over 7%. As a result, corporate earnings only fell 14% or so. In the 1981-1982 recession real growth again went down, but due to high inflation nominal growth rose, and again the impact on earnings was nowhere near as harsh as those consequences of the Great Financial Crash of 2008-2009.

Why the history lesson? If the past is prologue, then it may well be the case that the valuation compression in the S&P 500 seen year-to-date is not far off the bottom for equities troughing unless we see a subsequent credit event, which means there may be reasons for tentative signs of optimism over the balance of the year. Whilst the S&P 500 suffered its worst first half since 1970, this is not an indication of what is to come. Historical analysis implies there has been little or no correlation between the S&P 500 Index’s performance in the first and second half of the year.

Perspective is important when we try to gauge both investor sentiment, and the consequences resulting from a bear market for equities. The type of bear market is as important as how we respond to it as investors. Fortunately, Peter Oppenheimer, the Chief Global Equity Strategist at Goldman Sachs, has done a deep dive analysis on the types of bear markets that have been observed in the past. He classifies bear markets into three types: Structural, Event Driven, and Cyclical.

He deems both the Technology Bust in the early 2000s, and the Credit Crunch of 2008, to have been structural, and they tend to be the worst type, typically seeing equities fall 60% over three years, and then taking another ten to regain their previous peak. Event driven bear markets would include the stock market crash of 1987, and the COVID-19 slump seen in 2020. These fall around 30% on average, but within a much shorter six-month window, before recovering lost ground within a year.

Goldman Sachs view the current episode as being mainly in the cyclical camp. Cyclical bear markets fall, on average, around 30% over two years, and then take another five to climb back to the peak. However, sentiment currently suggests this one will probably play out faster, as the effect of resurgent inflation is already evident in changing consumer behaviour, and central banks currently appear to be serious in their intention to reduce inflation sooner rather than later.

The focus of the Federal Reserve, as it raises US interest rates, is on financial conditions, which Bloomberg helpfully package together as an index. The Bloomberg US Financial Conditions Index tracks the overall level of financial stress in the US money, bond, and equity markets, to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.

As can be seen on the chart below, outside of the collapse during the onset of the COVID-19 pandemic, US financial conditions are as tight as they have ever been in the last decade. Moreover, with the Federal Reserve intent on hiking, at least through the balance of the year based on market forecasts, conditions could tighten further.

It could be suggested that it is time to throw in the towel on equities, given the pervasive weak sentiment and the likelihood of recession, which in all probability, will lead to rising unemployment and earnings downgrades, further hampering the progress for stocks. However, the stock market’s job is to act as a discounting mechanism, and the market now appears confident that the economy will slow rapidly, and a year from now inflation will be a secondary worry.

Whilst that does not mean equities will immediately bounce back, absent a credit crisis (as mentioned above), there are grounds to believe most of the repricing for future slower growth expectations is broadly priced in. Moreover, there remain investments that offer both relative protection, and opportunities for discrete gains, despite the backdrop of weaker market conditions. We remain alert to these, and are reflecting those exposures in our asset allocation across Investment Strategies where appropriate.