A Summer Rally?
10 8 月, 2022
Harmen Overdijk, CFA
In July, global equity markets, apart from China, enjoyed a strong rally, reversing some of June’s losses. This was driven by solid corporate earnings, as well as receding inflationary pressures. We expect stock prices to rise further during the remainder of the year as U.S. recession risks and inflationary pressures recede. The risk for equity markets could be next year if the Fed continues to raise rates into 2023.
The recent strong employment numbers in the U.S. strengthen our conviction that U.S. growth will hold up over the next 12 months. That reduces the risk of a recession in the near term, but it raises the risk that inflation will stay elevated.
Isn’t the U.S. Already in a Recession?
The U.S. second-quarter real Gross Domestic Product (GDP) estimate came in at -0.9%. While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, it is often technically deemed a recession. That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. There is a chance that real GDP growth in Q2 will ultimately be revised into positive territory. Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1.
More importantly, every single U.S. recession has seen an increase in the unemployment rate. So far, that has not happened, and there is good reason to think it will not happen for some time. There are 1.8 job openings per unemployed worker. In the near-term, most people who lose their jobs will be able to find a new one easily. The recent U.S. Employment Report sent a robust signal about U.S. economic conditions. U.S. nonfarm payroll employment surged by 528,000 in July – more than twice the amount expected.
Job gains were widespread and led by the leisure and hospitality sector. Similarly, the unemployment rate ticked lower to 3.5% from 3.6%. Total nonfarm payroll employment and the unemployment rate have now fully recovered to their pre-pandemic levels. The strong job market is a key reason we believe the U.S. will not go into recession, or only a very mild one.
Corporate Earnings
The recovery in equity markets in past weeks was partly driven by stronger than expected corporate earnings. Although many companies issued warnings about an uncertain outlook, Q2 earnings were again very solid. Over 87% of S&P 500 companies have reported Q2 earnings thus far. According to data from Refinitiv, 75% have beaten analysts’ expectations in the past quarter – better than the long-term average of 66%. In addition, of the companies that issue earnings guidance for Q3, only 58% issued negative guidance, vs. a long-term average of 67%. It seems the outlook is holding up better than expected as well.
Notably, Energy companies are beating estimates by the widest margin. This sector alone has been holding up overall S&P 500 earnings estimates amid the deteriorating growth outlook. Meanwhile, Communication Services is the only sector posting negative earnings surprises so far. Similarly, Technology earnings surprises, though still positive, are underperforming overall S&P 500 earnings surprises.
The fact that sectors like Industrials and Materials are posting earnings surprises is notable given the demand rotation out of durable goods. Moreover, Consumer Discretionary earnings estimates had been subject to the largest downward revisions, and the fact that this sector’s Q2 earnings actually held up well suggests analysts were overly pessimistic about consumer spending. It shows that the bar for large downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.
Equity Valuations in a Soft-Landing Scenario
During the June sell-off, the market view was that stocks would continue to fall in the second half of the year as the global economy fell into recession but could then rally in 2023 as central banks began lowering rates. In fact, we potentially could see a reverse scenario, namely that stocks could continue to rebound in the second half of the year as the economy does not fall into a deep recession but then could face renewed pressure in 2023 as it becomes clear that the Fed and several other central banks are likely to continue to tighten monetary policies. A brighter economic outlook does imply higher inflation in the long term. Although stocks are not particularly cheap, they are also not expensive compared to long-term averages.
Another macro-economic driver to push stocks higher could come in the form of lower inflation numbers starting as early as next month. Treasury Inflation Protected Securities (TIPS) break-even yields are pointing to a rapid decline in U.S. inflation over the next two years. If the TIPS market is right, the Fed will not need to raise rates faster than what is already discounted over the next six months. Falling inflation will allow real wages to start rising. This will bolster consumer confidence, making a recession less likely. However, this decline in inflation could create another problem down the line because as inflation falls, real wage growth will turn positive. Rising real wages can boost consumer confidence and spending. A reacceleration in inflation in the second half of next year could prompt the Fed to start hiking rates again in late 2023, thus potentially creating a recession not in 2022 but in 2024.
Europe’s Energy Crisis
Although the odds of a proper recession in the U.S. are probably lower than widely perceived, the probability of a recession is higher in Europe. Four years ago, German diplomats laughed off warnings by President Trump that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch.
In Europe, a recession is more likely than not in the second half of the year. We expect the recession to be short-lived, with European governments moving aggressively to mitigate the fallout from gas shortages through various income support schemes for the private sector.
The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU. In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not account for any additional energy that could be generated by increased usage of coal-fired or nuclear power plants.
China
Chinese growth should rebound in the second half of the year. However, the threat of continued lockdowns, the shift in global spending away from manufactured goods toward services, and the weakening property sector will continue to weigh on activity.
Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target does not look achievable.
The Chinese property market is probably in a secular downturn after two decades of breakneck growth. If a weakening property market were to cause a banking crisis, similar to Europe and the U.S. in 2008, this could destabilize the global economy. However, the Chinese government has many tools available to control the domestic banking system, so we do not think this is a major risk for now.
In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as slower Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures.
With the Twentieth Communist Party Congress slated for later this year, we suspect the authorities will provide a lot more fiscal stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address the structural problems in the property market, they will help keep the economy afloat.
A New Taiwan Crisis
At the same time, another Taiwan crisis has developed on the back of Speaker Pelosi’s visit to Taiwan, defying Beijing’s threats of “forceful” countermeasures. China has responded so far with a military show of force, but hopefully, this incident does not evolve into a military conflict. However, it does highlight the geopolitical risk that a crisis over Taiwan could create for the world economy.
The current tensions tie into the larger de-globalization trend that is occurring at the moment. The Covid-19 pandemic and the lack of travel and interaction have intensified distrust of China and accelerated the divorce of the U.S. and Chinese economies.
Fixed Income
In contrast to the equity market, bond markets have been relatively calm recently. Our view on fixed income has not changed. Eventually, government bond yields will have to rise, but in the short term, we expect them to stay more or less at current levels. Therefore, we have a neutral position on government bonds and prefer to generate additional returns by investing in U.S. corporate credit.
Generating Yield in Credit
We have advocated investing in credit for some time to generate a decent running yield. We think short-dated high yield bonds and private credit have an attractive risk-return profile at the moment.
U.S. high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8%. Thus, spreads could increase if the U.S. entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of U.S. high-yield debt and less than 1% of investment-grade debt held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense than previous ones.
That is why we believe corporate credit should be part of a diversified portfolio. Investors worried about default risk and losses should look at private credit as an alternative to high yield. While less liquid, private credit is collateralized, improving recovery rates in case of default and thus lowering investor credit risk.
Portfolio Positioning
We already positioned our core portfolios more aggressively in late May and early June for a potential rebound in equity markets. As we expect that markets can continue their recovery, we have not made changes to the portfolio in the past month.
We remain constructive on risk assets and keep a balance between growth and value in portfolios.
DISCLAIMERS & DEFINITIONS
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
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