Following this month’s economic data releases, it’s clear that the US labor market is strong, and inflation remains too hot. In essence, despite rapid hikes and hawkish rhetoric, the Federal Reserve’s policy has yet to fully sink its teeth into the economy. That’s not surprising—monetary policy tends to work with long and variable lags. But what effect will future hikes have on the economy and, by extension, the markets?
Faster Hikes, Higher Risk
The data we’ve seen to date suggests the need for continued outsized interest-rate hikes in the near term. This should release some steam from the economy by tightening financial conditions, in the form of higher interest rates, lower stock multiples, and higher credit costs. And yet, with these more dramatic but necessary steps, the odds of a “hard landing” have increased. At least, that’s exactly how the stock market interpreted the news, judging by its swoon following the release of the most recent inflation report.
Higher interest rates—both before, and especially after accounting for inflation—create a headwind for stocks, as they reduce the present value of companies’ future earnings. Notably, real (after-inflation) interest rates now sit at their highest level since late 2018, which is likely to challenge stock valuations (Display).
But even more than higher rates, the concern moving forward is that the market may increasingly price in a recession—one in which earnings decline due to economic headwinds. While long-term investors can and should look through a recession, it can be both uncomfortable and opportune for those ready to tactically invest capital.
Even with 2023 still months away, a few major questions are top of mind as we look ahead.
First, once inflation peaks (“when” is a question all on its own), does it decelerate rapidly or gradually? Why does this matter? Because the path for inflation will determine, to a large extent, the path for the Fed. The Fed’s terminal rate (the peak level for the Fed Funds rate) and the time it takes to get there will affect the economy and, importantly for investors, corporate earnings.
Next, what will earnings growth look like in 2023? Our base case calls for a slowdown in GDP growth, which would correspond to a downshift in earnings growth—we’ve penciled in flat EPS for 2023 vs. 2022. Yet a substantial amount of uncertainty reigns. Should stubborn inflation persist—forcing the Fed to be even more aggressive—our current bear case may become more likely. In that case, a clear and obvious recession materializes and earnings per share for the S&P 500 potentially fall by 10%–25%.
Finally, if an economic downturn occurs in the US, will the rest of the developed world follow? If so, how would the Federal Reserve respond…would they need to keep hiking interest rates to truly break inflation’s back? Or would they have the wherewithal to pivot, taking a page from past recessions and sharply cutting interest rates to stimulate growth?
We can’t say for sure—not without knowing exactly how inflationary pressures would respond to an economic slowdown. Yet the answer is critical to gauging the path of markets from here. We’d only expect to replicate the diversifying performance of bonds and the impact on stock multiples that we’ve seen in past recessions if the Fed is able to cut rates. If not, assets could underperform their historical precedents.
How Far a Fall, Potentially?
Broadly speaking, there are two ways we can estimate the potential downside to the equity market in a recessionary scenario. One way looks at the magnitude of past recession-driven sell-offs, while the other analyzes prior recessionary earnings declines and P/E multiple contractions.
Historically, market declines corresponding to recessions have averaged around a 20% drop from their peak. That’s similar to what we’ve already experienced earlier this year and not much lower than current levels. But the range around this median is wide.
What if we change the metric to a potential drop in earnings due to a recession, along with a fall in the market multiple due to investors’ unwillingness to take on risk in that environment? In that case, we might see something more like the bear market scenario we mapped out in our second quarter outlook—a market decline of another 10%–20% from current levels (Display).
Balancing the Risks
While the latest economic data paints a somewhat cloudier picture for the market, the balance of risks remains roughly even. Importantly, while the press (and even this blog) have focused on the potential for a recession and its impact on markets, that remains the bear case. It’s by no means a certainty. Furthermore, we don’t want to overreact to a single month’s data points—while the picture looks worse at the margin than it did two weeks ago, it shouldn’t shift our view dramatically.
As we’ve reiterated over the past several months, with so much policy riding on each month’s economic data, the markets face more fundamental macro uncertainty than usual. In turn, this fuels abnormally high market volatility around each data release. While we lack confidence in the direction economic data could take from here, we have a high degree of conviction that recent volatility will persist in the months ahead.
Buy, Sell, Hold?
What’s a long-term investor to do? Unfortunately, neither we nor anyone else can predict how the answers to our questions will unfold. What path will inflation take, what will earnings look like in 2023, and will the Fed be able to pull back once the economy definitively slows? There are too many variables at play to come down definitively one way or the other.
That said, long-term investors hold an advantage when dealing with uncertainty—a long time horizon. Having patient capital enables them to take advantage of near-term sell-offs to add to their allocation or to initiate positions in areas which have become more attractive in the wake of a decline. In a recent note, we identified four specific strategies to consider today given the uncertain landscape.
Finally, keep in mind that volatility will eventually pass. Markets will calm and new highs will be set in the future. For those looking out several years, today’s challenges may create opportunities.