Global markets sell off: Is recession in the cards?

By Mark Dixon, Chief Investment Officer and Jim Baird, Chief Investment Strategist
Plante Moran Financial Advisors


Executive Summary

• A combination of the intensifying crisis in Europe and fears of a potential recession (in the U.S. and globally) has spurred a flight to quality and abrupt
  contraction in equities and commodities.
• The U.S. Treasury market appears to be pricing in a “lost decade” of economic
  growth ahead for the U.S., similar to what Japan has experienced, although we believe that to be an unlikely scenario.
• The probability of a recession has risen in recent months. Although equities
  have corrected, if the economy does enter a recession, further declines in
  equities should be expected. The potential for policy mistakes remains a
  significant wild card.
• A high volatility/low return equity environment could persist for some time, but investors with a sufficiently long time horizon should be rewarded with returns from their equity investments that are superior to Treasuries or cash.

 

PMFA Special Market Commentary

Global equity and commodities markets have experienced fierce selling pressure recently as a result of a number of factors including the escalating crisis in Europe and indications that the U.S. (and potentially Global) economy is heading back toward recession. In a statement describing its most recent policy move (pejoratively named “Operation Twist”), the Federal Reserve signaled that economic growth has continued to slip to a perilously low level. Yesterday, regional Purchasing Manager Index (PMI) data issued for both the Eurozone and China came in below 50, which is a signal that manufacturing growth is at the cusp of contracting in those regions. This information, on top of the concerns once again rising about the sovereign debt crisis in Europe, was enough to push the S&P 500 down 3.19% for the day on Thursday September 22.

The 10-year U.S. Treasury rate ended Thursday at 1.71%. Given that the 10-year treasury rate has historically tracked closely to expected nominal GDP growth (more on this later), the Treasury bond market appears to be pricing in a “lost decade” of economic growth ahead for the U.S., similar to what Japan has experienced.

Commodities fell by approximately 4.5% on the day, and even gold, that tried-and-true crisis hedge, gave in to the deflationary pressures, losing over 3% (and another 6% on Friday as of this writing).

In the following pages, we examine the current state of the investment markets, as well as the likely consequences that a recession would have.

Is Deflation Winning?

In 2009, we wrote a piece titled “Inflation or Deflation?” In that commentary, we illustrated that the earnings growth of companies has closely followed nominal GDP growth of the United States over the last century.


Source: PMFA, Robert J. Shiller, “Irrational Exuberance” Princeton University Press, 2000, 2005, updated

Without economic growth, risk asset returns suffer, as investors are not willing to pay as much for an earnings stream that is expected to grow slowly as they would for an earnings stream expected to increase rapidly. Achieving earnings growth is especially difficult in a deflationary environment, as the typically positive contribution of inflation to nominal GDP becomes a drag. (Broad price levels are generally falling in a deflationary environment, not rising). The secondary effect of deflation is also negative for nominal GDP growth, as consumers also tend to delay purchases until the price of goods has dropped further, thereby hurting real economic growth.

In 2009, there was genuine concern that we were heading down a deflationary path, and there was nothing that the Fed, fiscal policymakers, or other central banks could do to stop it, due to the massive deleveraging trend that was underway at the consumer level. However, $700 Billion+ of economic stimulus and over $2 Trillion of Federal Reserve balance sheet expansion, combined with a natural healing of the business cycle, did ultimately generate inflation. In fact, it helped to put a floor on asset prices, and also led to the end of the recession and a rebound in economic activity.

However, this was not your father’s recovery. This recovery was not fueled by an expansion of consumer credit. This recovery was fueled by an expansion of borrowing at the government level, with the intention of buying time for consumers to rebuild their balance sheets. And despite a few hiccups along the way, it seemed to be working. However, with government stimulus in the U.S. running its course, and the U.S. consumer unwilling to significantly increase spending as they continue to deleverage, the economy is now limping along at a very slow pace –so slow, in fact, that a few of our trusted economic resources are now calling for a recession in the near future. And recessions are typically associated with disinflation or deflation.

Are the markets already pricing in a recession?

The U.S. Treasury market is definitely calling for a recession (or worse). With the real yield on 10-year Treasury Inflation Protected Securities effectively at 0%, and nominal yields on the 10-year Treasury at 1.71%, the bond market is priced as if there will be no real economic growth and a 1.71% inflation rate for the next ten years. As shown in the chart above, such an outcome occurred only during the Great Depression. While we believe it is very possible the U.S. will enter a recession sometime in the next 12 months, we do not subscribe to the idea that there will be no real economic growth in the U.S. during the next ten years. As such, buying Treasuries at a 1.71% yield does not seem like a good long term investment to us, despite the money flooding into Treasuries in recent weeks.
 
Other areas of the bond market are now priced for an average recession. High yield spreads relative to Treasuries are now exceeding 7%, which is typical of the spread levels reached during prior recessions. Of course, back in 2008, high yield spreads hit similar levels, and many investors started buying them up in bundles. Then Lehman Brothers failed, and spreads went to levels not previously seen (over 15%), eventually pricing in a depression in response to the financial crisis and ensuing liquidity crisis. At this point, it appears as though high yield bonds are priced for a recession, but are not priced for a financial crisis similar to that of 2008 and 2009. 

This brings us to the U.S. Stock Market. With a closing level on Thursday of 1129, the S&P 500 is priced at less than 13 times trailing earnings. Of course, as we have written in prior papers regarding the equity markets (the most recent of which can be found here), while P/E multiples look very attractive, the real issue with equities at this point in the cycle is the “E”. Profit margins have been incredibly strong over the last few years, as companies have taken advantage of lower interest rates, a generally favorable business environment, and productivity increases. As a result, profit margins are approaching the prior peak levels set in 2007. While companies are undoubtedly less leveraged, and their balance sheets are in excellent shape, a recession, if it were to occur, would still have a significantly negative effect on earnings. In prior recessions over the last four decades, the average decrease in profit margins was 29% from peak to trough. The range of decline is relatively broad, however, from 15% to 55%. If we do enter a recession, there is no telling how deep or long it will be. One commonly held view is that it could be comparatively shallow, as neither housing nor automotive sales (two areas that tend to be hit hardest in a cyclical downturn) ever fully recovered from the last recession. As such, the argument is that they would not likely be as hard hit in another recession, resulting in a drag on growth that is less severe than would typically be the case. Conversely, other mitigating factors, including the limitations on monetary policy tools for the Federal Reserve and the gridlock in Washington, could work against the effective implementation of monetary and/or fiscal stimulus, thereby exacerbating the situation. The successful execution of policy responses both in the U.S. and abroad (and the potential for policy error), in particular, seems to have the market very concerned.

It is our belief that the U.S. stock market is not yet priced for recession, and it is certainly not priced for a financial crisis. However, if economic data and policy initiatives continue to disappoint, a repricing of the market could happen very quickly. The probability of a recession has risen in recent months, and if the economy does contract, further decreases in value are likely from current levels. History suggests that a shallow recession might end as quickly as 8 months, while the most recent recession lasted 16 months, but recognizing the beginning and end of a recession in real time is difficult at best. Even then, the market tends to move in advance of the economy. Therefore, it is easier to view the opportunities within the markets over a longer term time frame, given current pricing and long term expectations for economic growth. Recessions come and go, but 10-year periods of economic deterioration or stagnation are incredibly rare.

As we look at the markets as they are priced today, we strongly believe that investors that have an investment time horizon of 10 years or longer will be rewarded by holding equities (not only in absolute terms, but in comparison to a 10-year treasury yielding 1.71%). But as we have stated in the past, the appropriate understanding of an investor’s risk tolerance and ability to withstand short-term decreases in value is critical to the design of an optimal portfolio. We anticipate that the next few years will continue to be characterized by a lower return/higher volatility environment, a business cycle that is shorter than what we’ve come to expect over the past three decades, and more frequent recessions. Investing in risk assets in such an environment requires patience, and the willingness to look to the long run potential of those assets. Therefore, we believe that all investors need to maintain appropriate cash reserves and own an adequate amount of risk-averse assets in their portfolio to provide peace of mind, support their spending needs for the next few years, and offer the potential to take advantage of lower prices in risk assets should they present themselves in the short run. We will continue to closely monitor events, capital market conditions, and economic data as we look for opportunities to invest in asset classes that allow for the potential to improve our clients’ risk adjusted returns within the context of their long term investment policies.



Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.