Throughout our business’ existence, we have frequently reminded people that Markets and Economies are not the same thing. The reason for reminding readers is that mainstream media conflate the two, implying that the ability to divine the economic outlook can predict market performance (usually equity market performance). The flip side to this is that markets are forward looking by nature, so theoretically should precede the economy, yet many studies have found that link to be tenuous at best. However, there are points when big economic events play a part in market return variability and shouldn’t be ignored – one of those is during recessions. However, as pointed out in our article on the dangers of market mantras, we show that not only do equity markets NOT always bottom before recessions (showing the weakness in their ability to predict economic activity), recessions are the type of economic event that can lead to meaningful performance deviation in portfolios.
Innova has noticed (as have many others) that in 2023, a recession in the US must be the most forecast recession in history – just about everyone is calling for a US recession – but at the same time, equity markets aren’t acting that way. Why? What is going on? There are probably a few things to look at here.
The resilience of the consumer
Most market commentators are pointing to resilient employment data, wage growth and housing. Unfortunately, these tend to either be coincident indicators, or lagging indicators. We have our own set of Leading Economic Indicators (LEI’s) that we have pointed to in the past showing that the probability of recession is uncomfortably high, and risk of equity market weakness also uncomfortably high:
Source: Bloomberg and Innova Asset Management
But what is actually driving this, and what does it actually mean for portfolios? First of all, when times get tough for businesses, they prefer to reduce temporary workers hours rather than cut permanent staff – so unemployment numbers are backwards looking, but looking at change in temporary workers year-over-year tell us if corporations are cutting back on their more flexible staff:
Source: Bloomberg and Innova Asset Management
We also see a slowing in manufacturing, not generally a sign of a robust economy into the near future. Numbers above 50 indicate expansion, below 50 contraction:
Source: Bloomberg and Innova Asset Management
So leading indicators are falling, and coincident and lagging indicators are strong. Why? Most likely because the rate hikes in the US, Australia, NZ, Canada – just to name a few – were from historic lows and at an unprecedented pace. The lagging effects of rate rises take time to sink in. Just look at the typical Australian psyche around housing – “the RBA paused, awesome, mortgage rates will be back down to 2.8% in no time. We should buy (as borrowing will be cheaper soon)/or we should sell at the same price as 18 months ago”…
We think that there is a high likelihood of economic slowdown in the US and globally – and Australia’s ‘Lucky Country’ mantra may not save even us this time[1]. When it comes to portfolios, what does it mean, since recession is something that actually DOES have a meaningful impact on portfolio performance.
Corporate earnings during recessions
Innova completed a detailed internal study of corporate earnings in market downturns and recessions. We tested across industries and regions. We found there were some large discrepancies to earnings and operating margins across industries and often across countries. There were some fairly expected as well as unexpected results as well. Not surprisingly, irrespective of region, Healthcare provided the greatest earnings and margin resilience, followed by consumer staples. Perhaps surprisingly, earnings in the energy sector remained strong as well (the reasons for this would be an entire article in itself). However, on average, we see earnings in recessions fall around 15% – 20%. When we look at equity markets across the developed world, we see earnings expectations for the next 12 months being roughly flat to down 1% (Australia down a bit more than that)[2] – that doesn’t marry up with an average recession or even downturn.
The chart below from Global research house Variant Perception shows that whilst US earnings are indeed falling (consensus is at -7.2% YoY for Q2[3]), 12 month forward implied consensus is 25.7% Earnings growth!
This tells us that equity markets aren’t pricing in the risk of recession, yet bond market volatility (which is the highest in living memory) is certainly suggesting that investors should be cautious. Generally, the bond market gets it right more often than the equity market – but that isn’t a reason for investment decision making – instead, look at it from a different angle. If there is a good chance of recession (which there is) and that isn’t in equity market prices (which it’s not), then you aren’t being paid to be 100% bullish on stocks – so don’t be. Reduce your allocations, as probability weighted, you shouldn’t be at maximum exposure in equities.
What does this mean for portfolios?
In Innova’s opinion, we believe caution is warranted. Being cautious has hurt our relative performance this year, as big Growth names have rallied strongly in the US, and defensiveness has lagged. However, we need to be evidence driven, and the evidence points to complacency in the equity market. We aren’t predicting a GFC-type recession where corporate earnings fell some 70%+, we’re not even forecasting recession, we’re saying the risk of recession is high, but it ISN’T in equity market pricing. When that happens, you enter the game of zero or hero – bet on the recent trend and hope it continues (making you a hero), but if it backfires, you didn’t really have any solid, evidence backed, fundamental reason for being there in the first place (zero). We’d rather let hard work, deep and tested research along with evidence be our drivers. At the moment, they’re telling us to be cautious, we’d advise the same to others.
But what if we’re wrong?
It will show up in the data, and that is not yet happening. True leading indicators will begin to turn positive, and we will pick them up as they flow through our models. Yes, it would have meant a short period of underperformance, but given that during an average recession earnings fall 15% – 20%, and that doesn’t include ‘multiple compression’ in valuations, we think the risk/reward trade off is too skewed to the downside. As custodians of our clients’ capital it is our job to do our best to protect and grow it – so we’re happy to have softer performance for a short period of time if it drastically reduces the risk of large capital losses on our clients’ capital. It’s our job to keep our heads when others are losing theirs.
[1] We have an amazing ability to be in the right place at the right time. Since the “recession we had to have” in 1990/91, we avoided the ’94-‘96 recession (but not without equity market weakness), the tech-wreck (as we conveniently didn’t have tech as big part of our economy), the GFC (Thanks China for the materials demand) and potentially one in 2015/16 (Yay for the east-coast property boom). Whilst most chock these up to good fiscal and monetary Governance, honestly, Innova believes it was simply luck. Maybe we’ll be lucky this time, and Chinese Fiscal stimulus will pull us through without a recession – but we doubt equity markets will go unscathed
[2] A hat-tip to Lachlan and Tom at DNR Capital for sourcing that information for us
[3] Source: Rosenberg Research
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