If you've been wondering if you should sell all your stocks and run, I can guarantee you're not alone. In fact, if you haven't asked yourself this question, than you probably should... because it's important you understand the implications of what can potentially occur during this recession.
First, let's talk about the recession that's near confirmed.
Until now, there's been a lot of calls about recessions – which have been increasing a lot lately. I had first talked about a potential recession in March or so this year on TikTok (so, hope you're following).
We also had a flash inversion of the 2yr/10yr spread in April of 2022. In case you don't already know, since 1980 there have been four recessions and all of them were preceded by a yield curve inversion; in other words, when the 2-year yield is higher than the 10-year. This indicates the bond markets concerns with future growth, which is especially tricky in an inflationary environment.
But, all that was hypothetical until we had our first quarter GDP come in negative. The Q1 2022 GDP was revised to be slowed at -1.6% YoY. We would be in an official or technical recession if Q2 GDP if confirmed to be negative as well (i.e. two quarters of negative GDP growth). My intuition had already told me we were in a recession. But, that was further confirmed last week when Atlanta Fed's GDPNow model predicted Q2 was -2.1 percent! Yikes...
So how does this GDPNow model work? Is it just based on feelings and the word on the street? Well, it's a bit more complicated than that. They use similar modelling as to how the official GDP is calculated, which you can find out more about by visiting their website. Basically, they've historically been close to accurate... and I wouldn't take this lightly. Personally, I'm taking it as confirmation that we are, in fact, in a recession.
Another interesting confirmation that's likely about to come, is from the US Conference Board's Leading Economic Index, which has been negative 3 months in a row. Each time this has shown 4 consecutive negative readings, in the past 60 years, we were already in a recession. The 4th comes in July 21st.
But wait, there's more... (bad news)
There is a ton of bad news and data out there, which I can go over... but I'll just focus on the more recent ones which I find noteworthy.
Consumer confidence continues to slide, which will weigh on overall expenditure, and their expectations of the economy are near decade lows. It doesn't really take much digging to see why this is happening. Looking at PCE numbers (personal consumption expenditures) which came out last week, we can see that though disposable personal income is higher, it's in fact negative when adjusting for inflation... but more importantly, the same goes of expenditures. Consumers are spending less money in real terms. That's the beginning of a recession. Inflation and rising rates is one heck of a combination.
You can see this new found (lack of) confidence in the net outflows for the first time in these dips with ETF traders. That means that most people are now getting ready to (if not already) throw in the towel. By definition, this is capitulation – maybe just the beginning – which is quite scary, quite honestly.
Another reason why I think we can go lower is because until now, we've had multiple compression (and come down a lot because of it) but we have yet to see a meaningful earnings compression – which can come in the quarters ahead. As you can see, analysts have yet to downgrade their earnings expectations and S&P price targets – which suggest a 17% upside from here (lol?).
At some point, bad news is good news.
Commodity prices, most notably oil, has cooled over the past month. This is likely from all the negative data we've been getting on weakening demand. But, it's worth mentioning that some people are still calling for $150 a barrel.
Inflation expectations has been coming down too, which is reflected in bond prices rallying and yields dropping. Perhaps the bond market has bottomed, and we can buy them again.
But, at some point, the bad news in the economy equates to good news in the stock market. That'll definitely happen when we believe inflation has peaked (or positive news out of Russia/Ukraine) and the Fed pivots.
How deep will this recession be?
The question you need to think through, before you decide whether you pull out or not at this point (keeping in mind markets are forward looking by 6-9 months), is how deep will this recession be?
You can go look at the different recessions from history and try to form a base case, but they essentially come down to do main outcomes – a nasty, prolonged recession or a quick, short one.
Nasty, Prolonged Scenario
- Inflation sticks from further "supply shocks" after, perhaps, an initial slowdown. Repeat of 1970s. Real rates need to go much higher, and destroy everything. This seems to be the most common bear thesis, and quite possibly the worst one. We'd need another black swan for this to play out, imo.
- We've been in a negative real rate environment, and I believe going deeper into positive territory will achieve destruction.
- This would also mean that equities and earnings will go much lower, and there is more pain to come, just like 2002 and 2008. Corporate profits have had a steep incline in the past two years, and we'll see a sharp decline. This view makes sense to me.
- There's a possibility that inflation turns to deflation as we comp the high numbers, and natural boom & bust cycles of the economy – where the Fed doesn't need to do much. This would be similar to the post-WWII 1948-1949 period. This scenario also makes sense to me. Though, this recession lasted 11-months. I am hopeful we can rebound sooner.
Quick, Short Scenario
- A short recession would be considered a "soft landing" imo. This would be where the recession lowers demand sufficiently back to 2% inflation and growth can make it's way back from there slowly, but surely. We may see sticky commodity prices, but not enough to kill demand. A bit too utopian, if you ask me.
- Not happening imo, but this would have all just been a growth scare and everyone would be wrong (lol). But, hey, you never know. This could be a repeat from 2006. Often times, most people can be wrong.
Taking all this in, you should form your own opinion (because nobody has a crystal ball)... but I'll give you mine. And how will the markets react?
What kind of recession will we have? I think this recession will be it's own beast, as they always are. We can benchmark different scenarios, but the truth is "this time is different" in its unique way, of course. Imo, it will be a hybrid between all the scenarios I've mentioned. Corporate profits will decline considerably, and we'll even see potential deflation in areas outside of oil/commodities. In order for the best outcome, we need a resolution to Russia/Ukraine, and oil supply. How long this lasts, totally depends on what the Fed does.
What will the Fed do? The Fed obviously doesn't want to tank the economy and asset prices which destroy the Boomer's retirement funds. The tools used in 1970s can't be used anymore, without significantly more damage to an entire demographic. So, although they may not cut anytime soon, I don't think they stay hawkish either. This is the post-WWII scenario. The Fed, also reversed course every time the PMI reached or went below 50. Would this time different?
How will the markets react? This is tricky, because we may be chasing a moving target. If we agree that markets are forward looking by 6-9 months, and earnings will continue to deteriorate, then we still have another 15% to go based on previous bottoms in S&P forward P/E of 14. But, the stock market will get better as the economic data appears to worsen. Given, I believe the Fed has to pause these rate hikes in the short-term, I believe we are close to a short-term bottom.
Buyer Beware. I am, however, not ruling out that we may have a "second wave" of supply shocks which put us back into the 1970s scenario and the Fed has no choice but to destroy demand. This could take years to play out, in which case we are likely far from the bottom... and this can get (as Elon Musk called it) "super bad". I would exercise caution until we see a solution to commodity prices, imo. I'd keep at least 50% of my capital allocation for equities on the sidelines given the current uncertainties. It could take a year or two of having capital on the sidelines with negative real rates... but, I'll take -1% over -50% any day.
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