A Recession Is Coming, But Markets Aren’t Listening
I’ve returned to the markets after 28 trading days away* to find that a new narrative of approaching recession is swiftly taking hold. However, if you look at the markets, the tale isn’t represented in asset values, which are still influenced by the Federal Reserve. This poses both a risk and an opportunity.
Let’s start with the positive news: Prices that are affected by monetary policy have dropped dramatically. A great deal. The 0.85 percent Austrian bond due in 2120, which is most vulnerable to the future value of money, has lost 60% of its value since its high in 2020. Cathie Wood’s ARK Innovation ETF, ARKK 5.02 percent, is the stock fund counterpart, with earnings for most of its assets far in the future, and it is down more than 70% from its high.
To be honest, this is the kind of positive news that investors in Austrian debt or speculative tech companies don’t want to hear. Rate-sensitive equities, on the other hand, are significantly cheaper now than they were previously. The same holds true across the board: the higher the valuation, the longer the time to repay, and hence the greater the losses, since tighter monetary policy has made waiting more painful. (To put it another way, higher interest rates boost the incentives for short-term cash savings, making investing money into items with long-term gains less appealing.)
Growth Stocks Are Undervalued
These losses might worsen if the Fed becomes much more aggressive. However, futures traders are predicting a significant amount of monetary tightening, and rate-sensitive companies have responded with significant price and value drops. Microsoft, for example, has declined from 34 to 24 times anticipated 12-month forward earnings since the beginning of the year, despite expected earnings rising. The S&P 500 as a whole has experienced a similar trend, with the forward price-to-earnings ratio falling from 22 to 18, while Wall Street has raised its profit projections.
When a lot has already been priced in, the chances of profiting from such assets in the future improve.
Regrettably, only monetary policy is explicitly priced in. The bad news is that, despite all of the discussion of a recession, markets and bonds don’t seem to be reflecting any danger.
True, credit markets are in a funk now that they’ve realized the probability of recession is increasing. Last week, junk bonds with the lowest rating, CCC, fell, while corporate bonds fell across the board.
However, the best gauge of risk for mainstream junk bonds with a BB rating—the additional yield, or spread, given over safe Treasury yields—is just slightly higher than it was in mid-March. Even CCCs had a wider spread in December 2019 than they do now. While some recession risk has been factored in, corporate bonds are anticipating a mild recession that will affect primarily the weakest corporations. Bond investors have so far shared expert forecasts for a “soft or softish” economic landing.
Higher Yield, But Not By Much
Because share prices are influenced by so many diverse sources of news, it’s more difficult to determine how much recession risk is priced into stock markets. However, the market does not appear to be prepared for a severe recession, or perhaps a recession at all.
The market is showing signs of anxiety. Equities in the economically sensitive industrial sector, as well as spending-sensitive consumer discretionary stocks, have performed poorly, even when technology businesses such as Amazon are excluded. Consumer staples and utility companies have been flat for the year, since they should be better equipped to withstand economic hardship. This isn’t the post-dotcom bubble, when industrial equities lost a third of their value and consumer staples companies gained.
The likelihood of a recession has clearly grown, with the European economy in free decline, China in panic, the Fed tightening swiftly, and consumer confidence in free fall.
Even yet, I believe a recession is still a long way off, if at all, given the labor market is healthy and the Fed has only recently begun to raise rates, which are still absurdly low. The problem is that markets are increasingly reflecting this viewpoint, while the risk of being wrong is increasing.