Recession or not, it is time to reload
06 July 2022
Whether or not the first semester of 2022 will be qualified as a recession, the market is currently looking to rise from its ashes.
On the day of the June FOMC meeting, the Fed Fund futures were trading at 3.5% for Dec-22 and 3.75% for Dec-23, i.e., the market projected one hike to occur during 2023. At the same time, the Fed's Summary of Economic Projection (SEP) implied the same rates: the Fed, as often, matched the market consensus.
But during the last couple of weeks, the bond market movements suggested a slowdown in the Fed's hiking pace and substantial rate cuts for next year. Indeed, the entire short-term forward curve moved down and flattened. The Fed Fund futures adjusted accordingly, with the Dec-22 now at 3.25% (vs. 3.50%) and the Dec-23 at 2.75% (vs. 3.75%).
This year, the spread between Dec-23 and Dec-22 has been positive, hovering around +50bps. But, after a sharp move, it is now at -50bps, i.e., in about three weeks, it went from pricing two hikes between December 2022 and December 2023 to pricing two cuts.
Impact on our Investment Case
Recession: will it be official or not?
Our economic growth indicators suggested we started the growth slowdown more than a year ago and are now in a recession. For example, Copper, a commodity-based growth indicator, declined by more than 22% in a month. Even the “GDP nowcast” from the Fed of Atlanta, which historically slightly overestimates GDP, currently gives a Q2 GDP of -2.1%. Thus, with a second consecutive quarter of negative growth, the recession is de-facto here.
The market acknowledges it, but officials always take longer to determine a recession; sometimes more than a year after the facts, e.g., the Covid-19 recession (from February 2020 to April 2020) was officially declared only in July 2021.
The National Bureau of Economic Research (NBER) officially declares recessions. They do not consider the famous "two consecutive quarters of negative real growth" as the indicator. More precisely, the NBER's traditional definition of a recession is "a significant decline in economic activity that is spread across the economy and that lasts more than a few months. The committee's view is that while each of the three criteria—depth, diffusion, and duration—needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another". Also, they emphasize that their analysis "is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real Personal Income Less Transfers (PILT), Non-Farm Payroll employment (NFP), real Personal Consumption Expenditures (PCE), wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions".
While recessions essentially correspond to at least two consecutive quarters of negative growth, there are historical instances when a recession was declared without having this criterion met or the converse. For example, the recession from March 2001 to November 2001 did not include two consecutive quarters of negative growth. The two successive quarters of negative growth in 1947 were insufficient for the NBER to consider that period a recession.
Thus, the NBER looks at the state of employment, income, production, and consumption to determine a recession. While we start to observe some froth on the job market, the latter is not yet at recession levels. This may lead NBER not to recognize the first semester of 2022 as a recession.
Recession: the key to a FED pivot?
Being or not in a recession influences policies, both fiscal and monetary. With the coming mid-term elections scheduled for November, we think the debate over the current downturn should be heated, and politicians will take time before recognizing the recession.
However, a recession may bring forward the long-awaited monetary policy shift, as a substantial slowdown in economic activities deteriorates the job market, the other Fed's mandate. The bonds market is thus already pricing such an outcome.
The official Fed mandate is to promote maximum employment and stable prices. As mentioned in our mid-year outlook, the Fed is currently only focused on bringing inflation down at the expense of a recession and potential job losses. Note that the first killer of inflation is, in fact, a recession. However, a negative NFP will raise questions regarding its current policies, especially as we believe inflation could drastically go down in the coming months, thanks to base effects and easing in various non-sticky components that massively contributed to the recent high inflation prints. Note that the Fed's preferred measure of inflation, core PCE, is already printing its 4th lower high at 4.7%, and so is in a downtrend.
Currently, the Fed does not acknowledge the recession using the argument of a strong labor market. Moreover, given the high inflation prints, it continues to load its bullets, i.e., rate hikes, officially to fight inflation and unofficially to have ammunition to fight what appears to be an inevitable recession.
Recession: time to buy?
Stock market bottoms usually happen in the midst of a recession, and the current drawdowns in the sectors we invest in are in line with historical standards. Moreover, our sectors are typically the ones that start a new cycle ahead of the general market bottom. An old and robust market saying is that "the time to buy is when there's blood in the streets." In other words, buying during a recession offers the best investment returns. While we do not have a crystal ball for timing the markets, there is little doubt that we are in a recession, irrespective of what officials may say.
The bond market signals the recession is here and, consequently, substantial Fed cuts next year. In other words, it brings forward the long-awaited Fed pivot, which should function as a support for the overall markets.
Historically, the bottom of the stock market happened during the recession, and sound investors should not wait for the recession to be over nor to be officially announced. Recessions are eventually very opportune times to buy, especially for long-term investors.
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