Investment Strategy

So, are we in a recession?

Jul 29, 2022

Markets are rallying despite GDP contracting and higher rates on the horizon. What gives?

Our Top Market Takeaways for July 29, 2022

Market update

Well, technically…

 

A day after the Federal Reserve raised its policy interest rate by another 75 basis points (bps), the data for U.S. GDP from the second quarter showed that the economy contracted again.

Let’s start with the big debate: Should we characterize the current economic environment as a recession? The simple case for this is that GDP growth has been negative for two quarters in a row. Technically, that’s a technical recession.

But we think the focus on the recession debate could be distracting investors from the more important signals that came from the GDP release and the Fed’s meeting on Wednesday.

The first takeaway is that rate hikes are having their intended impact. The economy is slowing, and quickly. The housing and goods sectors are going through a substantial slowdown. Together, they dragged second-quarter GDP down by ~1.8%. All of the other major housing-related economic data released this week came in below economist estimates, and companies from Weber Grills to Stanley Black & Decker reported ugly quarterly earnings reports.

The second is that we are probably closer to the end of the Fed’s rate hiking cycle than the beginning. The Fed acknowledged this backdrop of slowing growth in its policy statement. And while its primary focus is still on getting inflation back to target, in the press conference, it hinted that the worst of the tightening cycle is probably over. Two ideas help support this view.

The first is that the Fed thinks it is close to “neutral,” or the theoretical interest rate that neither stimulates nor restricts economic activity. This is important because a guiding principle for this tightening cycle has been to get to neutral as quickly as possible.

Next, Fed Chair Powell said that it would probably be appropriate to slow the pace of rate increases once the Fed gets into restrictive territory. Because its next move will get it into restrictive territory, it follows that smaller rate hikes are likely going forward. This aggressive rate hiking cycle has been the primary reason for the poor performance from both equities and bonds so far this year, so smaller rate hikes should be welcomed by investors.

This chart shows the fed funds target rate with expectations, from December 2015 until December 2023. The first data point came in at 0.38% and rose to 1.13% by November 2017 and 2.38% in May 2019. It then fell to 1.63% by November 2019 and back to 0.13% by March 2020. In February 2022, the Fed began liftoff—rates rose to 2.375% by July 2022. The market expects it to rise to a high of 3.3% by February 2023 before falling back to 2.9% by December 2023.

Instead of getting distracted by the “recession” debate1, the weak GDP report and the Fed’s meeting give us added confidence in our view that the deteriorating growth backdrop and falling inflation will enable the Fed to stop raising interest rates early in 2023.

In markets, that means a sigh of relief, recession or not.

Spotlight

Rally on, Wayne

 

For both equity and bond markets, it doesn’t really seem like anything has gotten better. Europe is still facing an energy supply crisis, inflation hasn’t abated, growth is slowing dramatically, the Fed is still hiking aggressively, the housing market is rolling over, and consumer sentiment is in shambles.

But something must be changing.

Broad equity markets have rallied by ~11% from their early June lows, 10-year bond yields are down over 80 bps from their year-to-date highs, and the Bloomberg Aggregate Bond Index has rallied by over 5% from this year’s lows.

Back in May, we laid out the potential criteria for a bottoming market: [1] a peak in inflation, [2] a change in tone from the Fed, and [3] at least avoiding the worst case outcomes in Europe and China.

On [1], the news on inflation has actually improved despite June’s scorching CPI report. Crude oil, like bond yields, peaked on June 14. Coincidence? Probably not.

Way back then, it seemed like spiraling gasoline prices would force the Fed to raise interest rates even more aggressively to help contain inflation expectations. Instead, crude prices dropped 21% and took off some of the inflationary heat. Further, retailer earnings reports have consistently shown increasing inventories and an appetite for markdowns to clear them. Inflation has been stubborn, but it is looking more likely that it has indeed peaked.

On [2], the Fed’s press conference confirmed what the market may have been suspecting: that the Fed wasn’t going to hike rates by 75 bps at a time forever. The expectation from here is that we get a slower pace of rate hikes in the fall. As a result, 2-year Treasury yields have dropped from their high of ~3.5% to ~2.85%.

And on [3], the situation on the ground in both Europe and China is still fluid, but it doesn’t seem like it is getting materially worse. In a year when markets are bruised, sometimes a break in the bad news counts as good news.  

Under the surface, it is also notable that markets are rallying on what would have been characterized as “bad” news. On the day the Fed hiked rates by 75 bps, the long-duration secular growth stocks like those that are in the Nasdaq 100 rallied by 2.5%. The index extended its gains after Amazon and Apple posted strong earnings, and it’s now at the highest level in two months.

On the day the GDP release confirmed a technical recession and material weakness in the housing sector, housing equities actually rallied by over 2%, and are now ~20% above their lowest levels of the year. On the single-stock level, O’Reilly, the auto parts dealer, missed its earnings estimates and cut its full-year earnings forecast yesterday, but the stock still managed to gain 2.5%.

This chart shows the S&P Select Homebuilders Index from August 2021 to July 2022, indexed to 100 = August 2, 2021. It began at 100 and fell to 95 by September 2021. It then rose to a series high of 115 by December before beginning its decline. It reached a low of 69 in June 2022 before rallying back to 84 by late July 2022.

We don’t know whether or not the bottom is in, but there have been enough glimmers of hope on the inflation and Fed tightening front, and so much damage already done to markets, that even a modest change toward better news can mean gains for markets.

Investment takeaways

Focus on conviction

 

While equity markets are staging a welcome relief rally, we don’t have a high degree of confidence in the near-term direction of travel. That is why we are focused more on areas where we feel better about the potential upside and downside. Core fixed income and preferred equities could provide the appropriate profile.  

  • Consider core fixed income as a portfolio ballast. Bond yields have fallen substantially over the last month, given the reasons we laid out above, but if the economy does enter a (real) recession, then we think interest rates have much farther to fall. Even after the bond market rally, we would still advocate adding to the asset class.
 
  • Look for pockets of opportunities in risk assets. Dislocations provide opportunity. Preferred equities have been at the center of this year’s dislocation because they contain both bond- and equity-like characteristics. We think at current price and yield levels, there could be a compelling opportunity for “equity-like” returns while maintaining an added layer of protection because you are higher in the capital structure. Even after the rally, it is our preferred risk asset at the moment.

 

For more on how these considerations fit into your overall plan, please reach out to your J.P. Morgan team.

 

1Even if you do think we are in a recession (we don’t), you’d have to admit that it is a pretty bizarre one. Over the two quarters that headline GDP was negative, the economy added 2.7 million jobs, the unemployment rate fell from 3.9% to 3.6%, the travel sector strained under excess demand, and consumer debt delinquency rates hovered near all-time lows.

Note: Preferred investments share characteristics of both stocks and bonds. Preferred securities are typically long-dated securities with call protection that fall in between debt and equity in the capital structure. Preferred securities carry various risks and considerations, which include: concentration risk; interest rate risk; lower credit ratings than individual bonds; a lower claim to assets than a firm's individual bonds; higher yields due to these risk characteristics; and “callable” implications, meaning the issuing company may redeem the stock at a certain price after a certain date.

Investing in fixed income products is subject to certain risks, including interest rate, credit, inflation, call, prepayment and reinvestment risk. Any fixed income security sold or redeemed prior to maturity may be subject to substantial gain or loss.

 

The S&P Homebuilders Select Industry Index represents the homebuilders segment of the S&P Total Market Index. The S&P TMI is designed to track the broad U.S. equity market. The homebuilders segment of the S&P TMI comprises the Homebuilding sub-industry. The Index is modified equal weighted.

The Bloomberg Global Aggregate Index provides a broad-based measure of the global investment grade fixed-rate debt markets. The Global Aggregate Index contains three major components: the U.S. Aggregate (USD 300mn), the Pan-European Aggregate (EUR 300mn), and the Asian-Pacific Aggregate Index (JPY 35bn). In addition to securities from these three benchmarks (94.1% of the overall Global Aggregate market value as of December 31, 2009), the Global Aggregate Index includes Global Treasury, Eurodollar (USD 300mn), Euro-Yen (JPY 25bn), Canadian (USD 300mn equivalent), and Investment Grade 144A (USD 300mn) index-eligible securities not already in the three regional aggregate indices. The Global Aggregate Index family includes a wide range of standard and customized subindices by liquidity constraint, sector, quality, and maturity. A component of the Multiverse Index, the Global Aggregate Index was created in 1999, with index history backfilled to January 1, 1990. All indices are denominated in U.S. dollars.

The Nasdaq 100 is one of the world’s preeminent large-cap growth indexes. The companies in the Nasdaq-100 include 100-plus of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

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Our Top Market Takeaways for July 29, 2022.

All market and economic data as of July 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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