Are Recession Risks Priced In?
Are recession risks fully "priced in" by the markets? A US recession looks imminent and the discussion in the markets has moved on to how deep it will be. Forecasts for a 'mild' recession will now abound. But when a key Fed economic model sees an 80% chance of a hard landing, you know things could get bad! And I've read with increasing regularity that equities have fallen so quickly, well ahead of profits, that 'equities have already factored in a recession.' As noted recently, the NFIB Small Business Survey is already signaling a recession is likely. While such doesn't guarantee a recession, it does suggest the risks of an economic downturn are markedly higher. In 2007, the market warned of a recession 14-months in advance of the recognition. In 2019, it was just 5-months. Notably, a broad range of data suggests recession risks in the U.S. are mounting. Our Economic Composite Index, which comprises more than 100 different economic data points, also warns of recession risks. The leading indicators look grim as well. For example, the Conference Board's leading indicator fell for the third month in a row in May and that now makes 4 declines in the last 5 months. That is normally the stuff of recession. The 6-month percentage change (which the Conference Board says is the best predictor) is already warning of a recession. But have stocks already discounted those recession risks? Stocks currently remain under selling pressure due to a variety of issues causing a repricing of valuations: Surging inflation. Aggressive Fed rate hikes. Reduction, or tapering, of the Fed's balance sheet. Lack of stimulus support from the Government. Rising inventories. Weakening retail sales. Declining real disposable incomes. High gas and food prices weighing on consumption. Since earnings remain highly correlated to economic growth, earnings don't survive rate hikes. Fed rate increases lead to earnings recessions. Not surprisingly, our composite economic index also suggests earnings have further to fall. During the previous four recessions and subsequent bear markets, the typical revision to consensus EPS estimates ranged from -6% to -18%, with a median of 10%. So far, those estimates have not fallen nearly enough. The problem with (current) lower P/E ratios is that while the 'P' has moved, the 'E' is on thin ice, and the cracks are starting to show. Therefore, if an earnings recession is coming, as the data suggests, then the current "bear market" cycle still has more work to do as earnings decline. The realignment of market prices and valuations is always a brutal process. Most likely, we are just starting the negative revision phase, which makes risk management in portfolios a key priority for now.