by Brian Levitt, Global Market Strategist, & Talley Léger, Senior Investment Strategist, Invesco
Have we hit bottom?
It doesn’t appear that U.S. stocks have fully priced in a recession yet. Technical indicators suggest the bottoming process is incomplete.
A mild reaction?
However, stocks have dropped enough to suggest that if the U.S. economy were to fall into a recession, the impact on stocks could be milder than many fear.
Markets lead the economy
By the time recessionary weakness seems plain in the economic data, the stock market recovery may already be in motion.
Brian: Which two of your indicators have triggered? What are you missing but wish you were seeing?
Talley: First, U.S. economic policy uncertainty seems to have peaked for the cycle.2 Second, U.S. investor sentiment in the form of the bull-bear spread is so bad that I believe it’s good from a contrarian perspective.3 However, there’s a difference between what people say and what they actually do. I’d love to see more sellers than buyers in the positioning data.4 I’d also like to see more fear in the marketplace. Finally, keep an eye on U.S. high-yield corporate bond spreads potentially widening enough to reflect the major credit event of the cycle.5 What do you think? As the Federal Reserve (Fed) tightens, have things started to break?
Brian: I suppose it depends on how you define “break.” Things feel like they have likely broken for speculative growth investors and for crypto enthusiasts, but I would characterize those as valuation adjustments given the new interest-rate regime. But clearly, we have to be mindful of a deterioration in economic activity as the Fed tightens policy. The good news is that the bond market’s expectations for inflation have been plummeting.6 The bad news is that with the U.S. Treasury yield curve inverted, the same bond market is sending a warning sign on the economy.7
Since we like to believe that the bond market is always right, this would indicate that the inflation narrative should become a thing of the past and the growth narrative should move front and centre. How worried are you about a significant slowdown, and what do you think that means for U.S. equity investors?
Talley: Judging by the pace of U.S. manufacturing activity, which peaked in March of 2021, I think that the slowdown has become so acute that investors should consider the possibility of a contraction.8 In a risk-off market phase, I’d expect government bonds (the top of the capital structure) to outperform corporate bonds and stocks (the bottom of the capital structure) and defensive sectors to outstrip their cyclical counterparts. Lo and behold, such negative sentiment has been expressed by risk-off declines in both the stock-to-bond and cyclical-to-defensive ratios since early April 2022.9
The real risk here is that the Fed may kill the “golden goose” by crushing growth in order to contain inflation. What do you think the Fed cares about more? Peaking inflation or getting the rate of inflation closer to its 2% target?
Brian: You’re asking the $30 trillion question. I’ll take the Fed at its word. Jay Powell has told us, in no uncertain terms, that the Fed is “acutely focused on returning inflation to our 2% objective.”
There’s no doubt that the risk to the cycle is elevated. However, it brings us back to what this all means for investors. The S&P 500 Index is already down by 22.4% from the cycle peak to the recent trough.10 Over the past 10 recessions, stocks have fallen by 31% on average from peak to trough.11 Is it reasonable to think that today’s market may have already priced in a good amount of recession risk? There are examples of worse outcomes, such as 2008, but I expect that if the economy were to fall into a recession, the impact on stocks would likely be relatively mild given how much they’ve already fallen.
Talley: I tend to agree. In fact, by the time recessionary weakness seems plain in the economic data, the stock market recovery may already be in motion. But that's a story for another day.
Brian: Right. Markets lead the economy, not vice versa. Believe it or not, the stock market was actually positive during four of the past ten recessions.12
Earlier, you had mentioned cyclicals versus defensives. What are your thoughts on style and size?
Talley: To your point, large-cap growth stocks have borne the brunt of the adjustment to higher bond yields and seem oversold to me. Symmetrically, they could be amongst the first to stabilize. Growth stocks are long-duration assets and highly sensitive to changes in the discount rate. If bond prices keep rallying amidst a stagnating economy and peaking inflation surprises, a lower discount rate may help U.S. large-cap growth stocks find their footing.
On the flip side, it’s worth pointing out that the deep-value cyclical energy sector and oil prices have started to correct meaningfully.13 My stylized framework for risk appetite and portfolio positioning suggests the next major wave of small-cap value outperformance likely awaits a “recovery 2.0” scenario, but I don’t think we’re there yet.
In my day-to-day job, most investors want to talk to me about the 6- to 12-month outlook. But as we wrap up this conversation, I think it’s important to take note of the longer-term considerations. In the grand scheme of things, how much will the past 6 months of drawdowns really matter to investors over the next 20 years?
Brian: You bring up a good point. Long-term thinking tends to get lost at times like these. The S&P 500 Index was up 9.5% per year over the past 20 years.14 Even with a global financial crisis, a European debt crisis, and a global pandemic among other challenges, an investor still would have doubled their initial investment once every 7.5 years.15
Talley: I think you’re right that long-term investors may ultimately be rewarded for staying the course. Perhaps it really is that simple?
Brian: It’s always good to chat with you.
Talley: You as well. This too shall pass.
- 1 Source: Invesco, Equity Strategy Special Edition, “Rising tail risks: From risk-off to risk-on and back again?” 6/10/22.
- 2 Source: Economic Policy Uncertainty, 7/12/22. Notes: The daily U.S. News-Based Economic Policy Uncertainty Index utilizes newspaper archives from Access World News’ NewsBank service.
- 3 Source: American Association of Individual Investors, 7/7/22. Notes: The AAII Bull-Bear Spread is the net percentage of positive (bull) minus negative (bear) survey respondents, where a difference of roughly -30% signals extremely negative investor sentiment.
- 4 Source: Chicago Board Options Exchange (CBOE), 7/12/22. Notes: The CBOE Equity Put/Call Ratio is a measure of seller (put) relative to buyer (call) positioning derived from the options market, where a ratio greater than 1 signals extremely negative investor sentiment. The CBOE Volatility Index (VIX) or so-called “investor fear gauge” is a weighted, constant, 30-day measure of the expected volatility of the S&P 500, calculated from out-of-the-money SPX options.
- 5 Source: Bloomberg, 7/12/22. Notes: The Bloomberg U.S. Corporate High Yield Average Option-Adjusted Spread (OAS) measures the spread of U.S. dollar-denominated, below investment-grade, fixed-rate corporate bonds above their Treasury counterparts. When the spread is wide, investors demand high compensation for taking risk.
- 6 Source: Bloomberg, 7/12/22. As represented by the 1-, 3-, 5- and 10-year inflation breakeven. Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality.
- 7 Source: Bloomberg, 7/12/22. As represented by the difference between the yield on the 10-year U.S. Treasury rate and the 2-year U.S. Treasury rate.
- 8 Source: Institute for Supply Management (ISM), 7/1/22. Notes: The ISM Manufacturing Purchasing Managers Index (PMI) is a direct measure of expectations captured by business surveys of production and the general economic climate. Diffusion indices have the properties of leading indicators and are convenient summary measures showing the prevailing direction and scope of change.
- 9 Source: Bloomberg, Standard & Poor’s, 7/13/22. Notes: The stock-to-bond ratio compares the performance of the Bloomberg U.S. Treasury: 7-10 Year Total Return Index to that of the S&P 500 Total Return Index. The cyclical-to-defensive ratio compares the performance of the cyclical sectors to that of the defensive sectors within the S&P 500. Cyclicals = Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensives = Consumer Staples, Health Care, Telecommunication Services, and Utilities.
- 10 Source: Bloomberg, 7/12/22. Performance is from the cycle peak on 1/4/22, to the low on 6/16/22. There is no guarantee that the 6/16/22 low is the trough for this cycle.
- 11 Source: Bloomberg, 6/23/22. Based on the S&P 500 Index and recession dates defined by the National Bureau of Economic Research: Aug. 1957 – Apr. 1958, Apr. 1960 – Feb. 1961, Dec. 1969 – Nov. 1970, Nov. 1973 – Mar. 1975, Jan. 1980 – Jul. 1980, Jul. 1981 – Nov. 1982, Jul. 1990 – Mar. 1991, Mar. 2001 – Nov. 2001, Dec. 2007 – Jun. 2009 and Feb. 2020 – Apr. 2020.
- 12 Source: Bloomberg, 6/23/22. Based on the S&P 500 Index and recession dates defined by the National Bureau of Economic Research: Aug. 1957 – Apr. 1958, Apr. 1960 – Feb. 1961, Dec. 1969 – Nov. 1970, Nov. 1973 – Mar. 1975, Jan. 1980 – Jul. 1980, Jul. 1981 – Nov. 1982, Jul. 1990 – Mar. 1991, Mar. 2001 – Nov. 2001, Dec. 2007 – Jun. 2009 and Feb. 2020 – Apr. 2020.
- 13 Source: Bloomberg, Standard & Poor’s, 7/12/22. Notes: S&P 500 Energy comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) energy sector. West Texas Intermediate (WTI) is a U.S. light sweet crude oil blend. New York Mercantile Exchange (NYMEX) WTI Crude Oil futures (CL) track front-month contracts for delivery in Cushing, Oklahoma.
- 14 Source: Bloomberg, 7/12/22. As represented by the S&P 500 Index.
- 15 This is a hypothetical scenario for illustrative purposes only. It does not reflect the performance of an actual portfolio.