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The Uncertainty May Be Worse Than the Slowdown

We do think the onset of recession is a time to tread carefully, but it could also be a time of opportunity for equity investors.

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Friday gave us a mixed U.S. nonfarm payrolls report. The headline number of 315,000 new jobs hid the fact that 100,000 were wiped out in revisions to the previous two months’ data. Wage growth was unexpectedly subdued, and the unemployment rate rose as labor force participation went up. For the first time in a number of months, people coming into the employment market are not finding jobs.

Strange as it may seem, the recent jitters in markets have been due to economic data being too strong. Inflation is high and likely to remain so for some time. Therefore, as long as there was job growth, the U.S. Federal Reserve was expected to keep hiking rates—and markets had to continue to brace for a further tightening of financial conditions.

But perhaps Friday gave us the first signs of labor conditions turning. If so, what might equity investors anticipate? A deeper, broad-based sell-off, as the economic slowdown arrives in earnest and sweeps through markets? Or something milder?

How Tight Is Tight Enough?

We’ve been saying for some time that equity markets can’t stabilize and begin a new ascent until fixed income markets have settled down. Until Friday’s jobs data, there was little sign of that last week, following Fed Chair Jerome Powell’s warning at Jackson Hole of “a restrictive policy stance for some time,” and a string of European Central Bank officials airing the possibility of a 75-basis-point hike. Equities appropriately pulled back from their recent powerful rally.

Fixed income markets are likely to settle down when central banks signal that financial conditions are sufficiently tight, and we think a key indicator for that will be the way those central banks respond when job losses actually begin to mount. Will the doves reassert themselves, or will the inflation hawks press for Volcker-style persistence? Powell’s recent speech certainly appeared to be preparing the world for the meaningful slowdown that he thinks might be in the cards.

We think the doves will reappear at some point, however—after all, the Fed has a dual mandate to promote maximum employment and price stability. But relatively strong economic and jobs data have been complicating this picture. In Europe, the scale of the stagflationary energy crisis clouds things still further.

We therefore anticipate further rates volatility and a weakening economy—and, as a consequence, we remain cautious on equities.

Recency Bias

Our caution due to current uncertainty around rates is very different from our caution due to the anticipated economic slowdown, however.

When it comes to recessions, it can sometimes pay to flip the old Wall Street adage around by selling the rumor and buying the news. Historically, equity markets have generally bottomed out before the trough in the economy.

Recency bias can lead to fears that the next downturn will come with a multiple-point decline in GDP and a high double-digit market sell-off, like the COVID-19 and 2008 crises. In reality, the majority of post-WWII U.S. recessions have been relatively mild, and there is good reason to believe the next one could also be mild.

For one thing, high inflation is likely to mean that nominal growth remains positive throughout, which would be supportive of corporate earnings and cash flow, or at least mitigate their declines. Corporate debt and interest burdens are also generally at moderate levels.

U.S. employment levels are high and job openings remain close to an all-time record; and the higher employment is at the start of the downturn, the less severe the eventual trough is likely to be. Consumer debt remains modest and savings remains relatively high. All this appeared to feed into last week’s much stronger-than-expected U.S. consumer confidence data.

The deep recessions of the recent past were triggered by severe economic shocks: a pandemic in 2020 and private-sector financial excesses in 2007 – 08. Those factors are largely absent this time around.

Dispersion

As a result, the decline in equity markets may be less correlated and therefore less severe than currently anticipated.

We already saw signs of that dispersion through the second-quarter earnings season.

In general, companies that have pricing power, free cash flow to deploy productivity enhancements, the nimbleness to manage their supply chains proactively and lower exposure to the cost of labor and raw materials are currently at an advantage. They have been able to weather inflation and maintain or build their share of rising nominal growth even in the face of falling real growth. Companies without these competitive advantages were generally forced to reduce their guidance.

We still anticipate ongoing volatility and high correlation in equity markets until the shape of the slowdown, the inflation outlook and the tightening cycle become clearer, and fixed income markets become more settled. But the current uncertainty may turn out to be worse than the slowdown itself: As the outlook clears, we believe the dispersion in individual company earnings and cash-flow performance is likely to be increasingly reflected in differentiated market pricing.

For equity investors, we do think the onset of recession is a time to tread carefully, but it is also a time to be ready for opportunity.

Joseph V. Amato , September 6

Article also available in : English EN | français FR

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