After 28 trading days away from the markets*, I’ve come back to find that a new narrative of impending recession is quickly taking hold. Yet, look at the markets themselves and even after Wednesday’s big fall the story isn’t much reflected in asset prices, which are still beholden to the Federal Reserve. This creates both risks and opportunities.
Start with the good news, such as it is: Prices sensitive to monetary policy have fallen a lot. Really a lot. The bond most exposed to the value of money in the future, the 0.85% Austrian bond maturing in 2120, has lost 60% of what it was worth at its 2020 high. The equivalent bet in stock funds is Cathie Wood’s ARK Innovation ETF,
where profits for most of its holdings lie far in the future, and it is down more than 70% from its high.
Admittedly, this is the sort of good news of which investors in Austria’s debt or speculative tech stocks probably don’t want to be reminded. But for people wanting to put money to work now, rate-sensitive stocks are much cheaper than they were. And the same goes across the board: The higher the valuation, the longer the time to be paid back, and so the bigger the losses as tightening monetary policy has made it more painful to wait. (A simplified way to think about it: Higher interest rates increase the rewards for short-term saving in cash, so making money into things promising rewards in the long run less attractive.)
If the Fed turns yet more hawkish, these losses could intensify. But futures traders are already anticipating a lot of monetary tightening, and rate-sensitive stocks have responded with big falls, not only in the price but also in the valuation. One example: Microsoft has dropped from 34 times estimated 12-month forward to 24 times since the start of earnings the year—even as predicted earnings have risen. Something similar has happened to the S&P 500 as a whole, where the forward price-to-earnings ratio is down from 22 to 18, while Wall Street has lifted its forecasts for earnings.
When a lot is already priced in, the odds of making money from such assets in the future increases.
Unfortunately, it is only monetary policy that’s clearly priced in. The bad news is that for all the talk of recession, stocks and bonds aren’t reflecting much risk.
True, credit markets are in a bit of a funk after finally realizing that the risk of recession is rising. Junk bonds with the lowest, CCC,
rating tumbled last week, and corporate bonds sold off across the board.
But for mainstream junk bonds with a BB rating, the best measure of their risk—the extra yield, or spread, offered above safe Treasury yields—is only just above where it stood in mid-March. Even CCCs had a higher spread than now in December 2019. While a bit of recession risk has been priced in, corporate bonds are prepared for a very mild recession at worst that takes out only the weakest companies. So far, bond investors share Fed Chairman Jerome Powell’s hopes for a “soft or softish” landing for the economy.
It’s harder to tease out what level of recession risk is priced into stock markets, since share prices are buffeted by so many different sources of news. Wednesday’s fall, triggered by bad results from retailers, recognized that recession risks are growing. But the market isn’t prepared for a deep recession, and barely even for a mild one.
Some concern is visible in the market. Stocks in the economically-sensitive industrial sector have done badly, as having spending-sensitive consumer discretionary stocks, even stripping out technology firms such as Amazon that are classified as discretionary. Steady earners in the consumer staples and utilities sectors are flat for the year, as they should be better able to resist economic weakness. But this isn’t like the post-dotcom recession, when industrials eventually lost a third of their value and consumer staples stocks rose.
The risk of recession has clearly risen, with the European economy heading down, China in a Covid panic, the Fed tightening fast and consumer confidence slumping.
Even so, I suspect recession is still a ways off if it hits at all, because the jobs market is stupid and the Fed has barely begun lifting rates, which are stillly low. The trouble is that this view is broadly reflected in markets, while the risk of being wrong is rising.
*I had a nasty bout of Covid-19.
Write to James Mackintosh at [email protected]
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