Recession Obsession

By David Nelson, CFA

U.S. markets put in their first up week in nearly 2 months. After coming dangerously close to the traditional bear market, down 20% the S&P struggled for a few days and then exploded higher. Nothing changes sentiment like price. We’ll see in the weeks ahead if sentiment readings from AAII improve.

(Click on charts to expand)

The risk-on backdrop is a welcome relief but doesn’t change the fact that the Federal Reserve is set to tighten financial conditions in an attempt to force inflation expectations lower.

On Friday, the Fed’s favorite inflation indicator core personal consumption expenditures price index rose 4.9% in line with estimates and a deceleration from March.

Now the debate surrounding peak inflation begins with many talking heads saying the worst is behind us. To even begin going down that path, energy needs to roll over or at least plateau. As I’ve said repeatedly in previous posts energy touches every line item of the income statement. The industrial complex and in turn the retail consumer only have a few choices. Both can cut demand which eventually shows up in reduced economic output or raise prices. Some industries have been reluctant to raise prices for fear of losing market share.

We saw how that decision worked out for Target (TGT) and Walmart (WMT) earlier this month. Both saw their biggest one-day declines since the crash of 1987 on the day of their reports.

Consumers raise prices too by demanding higher wages.

Recession Obsession

The above has both Wall Street and Mainstreet talking about a recession. As I pointed out on my most recent interview with Fox Business anchor Maria Bartiromo markets have already made that decision. A recession is likely late this year or early next. I expect after this week’s non-farm payrolls, the jobs market will start to show signs of deterioration.

Layoffs coming (MSFT, NVDA, SNAP announced cutbacks)

We’re already seeing changes in the labor backdrop as companies start to curtail hiring or consider layoffs. In the world of venture capital, boards and investors are encouraging founders to rethink business models and extend the runway. As in the public markets growing revenue without a pathway to profitability within a reasonable timeframe doesn’t cut it anymore. That’s why Free Cash Flow has been the rallying cry of stocks this year.

So, what happens to your stocks if we do get a recession? Intuitively it begs the question why own stocks at all?

There have been 12 recessions since World War II with GDP collapsing as much as -31% during the Financial Crisis to the garden variety of just a -1-2% hit. The range of stock performance is even wider. The -38% hit during the Dec 2007 – June 2009 recession to +20% return during 1953 – 1954 recession speaks to the uncertainty of stock performance during economic downturns.

Of the 12 time periods 5 of them saw price gains. The average decline during a recession over the last 76 years is -2.3%. (Different vendors come up with slightly different readings but the concepts are the same. Bloomberg and Wikipedia were the sources for this article)

Stocks are of course a discounting mechanism and often react well in advance of the actual event. At the lows, the S&P and NASDAQ 1000 were down close to -20% and -31% respectively.

The challenge and questions today are the following:

  • Will the Fed maintain its resolve and stamp out an inflation backdrop that hits those at the bottom of the economic pyramid the worst?
  • Current projections show an implied Fed Funds rate of 2.86% by Feb 2023 taking 8 hikes to get there.
  • Equity markets have priced in Fed Policy of about 3%. What isn’t priced in is the possibility they will have to go beyond current expectations forcing even tighter financial conditions.

What I’m Looking at 

If you believe the Fed can bring down inflation back to its 2% target anytime soon, then you’ll be able to go back to stocks that fell out of favor over the last year.

Prior to this year’s downturn, Growth at the RIGHT price morphed into Growth at ANY price. Over the last year that trade has been largely undone.

I think the Fed with a little help from improved supply chains will eventually get a handle on inflation, but I don’t think it will make it back to the 2% target anytime soon. Financial conditions will remain tighter than previous years.

In that mindset I have to have valuation support for any stock I purchase.

Peak Dollar?

Stocks have been struggling all year as the dollar continued to advance higher. Large Cap multinationals with significant offshore sales feel the drag as their goods become more expensive to purchase. Coincidence or the reversal of a trend? Last week’s explosive move off the bottom was reinforced by the dollar losing some strength across a range of currencies.

Are stocks following credit spreads or are credit spreads following stocks?

Widening credit spreads are an indication of economic concern as financial conditions tighten. During the March rally and the most recent one last week we saw the spread between investment grade corporate bonds narrow while stocks ramped higher. Who’s following who?

This Week

We’re coming to the end of earning’s season but a few notables this week. Salesforce (CRM) and HP (HPQ) Tuesday and CrowdStrike (CRWD) and Lululemon (LULU) Thursday. That’s it for me. Have a great week.

*At the time of this article some funds managed by David were long MSFT