Global economic growth is slowing down and, thankfully, inflation with it. It was only one year ago that the prices of goods and services were increasing by over 9% year-over-year in most developed countries, including the US – which is four times the annual rate of the past 15 years. Inflation, as we have discussed previously, can be detrimental to the health and well-being of economies and consumers. Much of the credit for the economic slowdown and resulting lower inflation must go to global central bankers who have been on a campaign to squash rising prices through an aggressive series of interest rate hikes. Econ 101 taught us that higher rates have the effect of slowing economies and stamping out inflation and this has been a casebook study in that regard. A job well done by central banks – so far. The key now for central banks is to keep the glidepath of the economy in slowdown mode or what is referred to as a “soft landing” and not allow the slowing growth to gain momentum to the downside, pushing the economy into recession mode or “hard landing.”
We are already witnessing some of the negative side effects of creating tighter financial conditions and engineering a slow-growth economy – a decline in corporate profits, along with falling stock and bond prices. This explains the recent number of companies missing their profit estimates, warning about future revenue growth, laying off tens of thousands of workers, and the 13-month-old bear market in stocks and bonds. Avoiding a potential recession or hard landing from this point will require inflation data to continue to fall, the Federal Reserve to be disciplined, yet flexible, as well as some luck.
Risk for Stock Markets?
Though we are pleased that this bear market in stocks and bonds has made significant progress in both time (13 months) and price (indexes have fallen at one point nearly 30%), a recession or hard/crash landing would cause a deeper decline in financial markets than most investors currently expect – in the territory of 40-50% for stocks. From these recent, higher stock index levels that could be a further decline of 25-35%, which creates the “ugly math” scenario that investors should be careful to avoid – hence our continued more defensive posture with your wealth. In our opinion, and based on our research, we are close to the end of this bear market in time, but perhaps not yet in price. The price of stocks today appears a bit too elevated given the continued risk of stubborn inflation and higher interest rates. However, data points are coming our way in the next few months that will likely resolve the hard vs. soft landing question and put an end to this bear market and welcome a fresh new business cycle and bull market. Here's what we will be watching closely during that time.
Inflation continues to decline in just about every sector except for wages, given the strong labor market. This is a large and important segment of inflation and one that policymakers are targeting as the last hurdle. In the past, wage inflation has been the “stickiest” component and required more interest rate hikes than markets expected. Though financial markets have experienced recent strength – similar to other short-term moves in the past year – investors should be careful at this point that inflation doesn’t remain stubborn. This would require more interest rate hikes and significantly increase the risk of recession and a deeper bear market. There are many data points that will be released in the coming weeks to help us gauge progress on the inflation front.
Fed and Central Bank Policy
Central banks have many indicators that they would like to see come together to cease their efforts to thwart inflation. The Fed usually stops raising rates (a market positive) when the Fed Funds rate (now 4.75%) is close to or equal to the inflation rate (now 6.1%). Though this data and other metrics are making progress, we are just not there yet. We will be watching Fed indicators such as this and others closely over the next few months.
So far this quarter, we can see the cracks in corporate profit growth due to the tighter financial conditions the Fed and other global policymakers have engineered. It will be important to keep a close eye on any continued profit deterioration as that would be a sign of impending recession or a hard landing. Often during the last phase of a bear market, corporate earnings growth falls hard and markets go with them – usually for the final leg down. We are hopeful that this can be avoided, but at this point it remains a risk for investors.
Stock Market Valuation
At current levels, global stock markets are not cheap. In fact, given a price-to-earnings (PE) ratio of 18.5 times earnings, one could argue that stocks are overpriced – unless inflation somehow falls to 2% in the next 4-6 weeks. Possible, but unlikely. At previous bear market bottoms, PE ratios have hovered around 14-16 times earnings, which is a level that would be much more appealing for us to be very constructive about becoming more growth-oriented. Given our current defensive posture, a decline in stocks to these levels would be a welcome opportunity. We are watching this closely.
Opportunities Until the Bear Market Comes to An End?
The bond market continues to provide an excellent chance to lock in higher yields than we have seen in more than a decade and our fixed-income team has been hard at work seizing this opportunity. In addition, even though stock markets in general have been in a downtrend, we continue to find isolated opportunities in companies that are able to profit from this environment, such as in the financial, healthcare, and consumer staple sectors. Hence our addition of positions in these areas from time to time.
The Bear’s End - Long Live the Bull!
We are getting very close to the end of this bear market, however, our research suggests that we are just not there yet. In the coming weeks and months, we will likely see the development of a new bull market. As we have mentioned previously, we have a list of equities across the globe to seize this opportunity. If for some reason data points come together quickly and the bull market starts in earnest, we stand ready to take advantage of the opportunity. We look forward to the new bull market and its arrival this year.