In recent months the US first quarter GDP was revised to -1.6%. The Q2 results are not yet in, but the Atlanta Fed publish a ‘GDPNow’ data series that is constantly updated as various data points flow in. The current prediction is that the US is headed for a -1.0% GDP result in the second quarter. By Australian definitions that would be a recession. The US body in charge of dating the business cycle, is the National Bureau of Economic Research. They don’t use the ‘two quarters of negative GDP’ that we use in Australia, but rather their own formula of the broadness of an economic downturn and recovery.
Needless to say, as a government body you can understand that they drive by looking in the rear-view mirror. So by the time they announce the start of a recession, we should be very close to the bottom.
While the Fed chairman Jerome Powell insists ‘we see no signs of a recession’, one could rightly ask, when did any Fed committee in the past warn of a recession? The only thing that the Fed can see right now is very full employment, (it always is at the top of a cycle) and inflation that must be tamed.
I believe that the Fed, and indeed the RBA (Australian Reserve Bank), do see the risks, but are on a path to get rates up to a reasonable level which; (a) appears that they are doing something to fight inflation, and (b) builds up their ammunition for rate cuts if and when the recession arrives.
Interest Rates
After 139 months of interest rates unchanged or going down, we’ve had our third month of interest rate rises. Today the Reserve bank lifted rates by 0.50% to 1.35%. Reaction in the five minutes after the 2.30PM announcement was a small rise of 0.23% in the All Ordinaries index indicating that the 50 bps cash rate rise was widely expected.
Market interest rates are already factoring in a series of rapid fire interest rate hikes by the RBA.
The futures market is expecting the official cash rate to be 2.00% by September and 3.00% by December.
In the USA, the futures prices are forecasting a peak in rates during November, when the rate is forecast to hit 3.25%. Currently the Fed Funds rate target is 1.50% to 1.75%, so that implies another 1.50% of rate rises.
However, what has happened over the last few weeks is that futures markets have started paring back the rate hike expectations. The December futures contract for Australia went from pricing 3.25% cash, back to 3.00% cash rate. The US futures markets have seen similar moderation.
Additionally, the bond markets also had something of a pivot around 14/15 June. The Australian 10 year bond hit 4.20% in the 15th, and has since fallen to 3.60%. The US 10 year bond hit 3.48% on the 14th of June, and is now down to 2.96%. Are the interest rate markets smelling a recession?
Equity Markets
In the third week of June the S&P500 index hit a rare milestone. It was down in nine out of the previous ten weeks. Since World War II there have been only three other periods that contained such a terrible run of weekly returns. One was in May 1970, another in March 1982, and the last one was April 2001.
In all three of those occasions, the USA was in the midst of a recession.
They all occurred between six and eight months before the economy bottomed out.
This sort of market behavior is associated with economic recession, not just a garden variety intra year correction.
We also know that the sharemarket is forward looking, so it is worth looking to those episodes for what happened next.
In 1970 the market declined another 12.8% before finding a final bottom.
In 1982 the market had a rally, but then went on to bottom out at 5.7% below the point where it had its nine in ten week losing streak.
In 2001 the market had a decent bounce, but then went another 14.4% below the level of the nine in ten week losing streak.
With that history, and the probability of a US recession, we think that there is some more downside risk in US markets.
Investments
The results for most multi-asset managers are not yet in for the month of June, but early indications are not good, especially when looking at plain vanilla indexes. The Vanguard Growth ETF was -13.25% from 31 December to 30 June, and for the full financial year was -9.45%. Likewise for the Vanguard Balanced ETF, the result was -12.48% for six months to June 30 and -9.9% for the full year.
In the USA, a 60/40 portfolio of share and bonds has returned -16.1% in the first six months of 2022, the worst performance since 2008, which was -20.1%.
What to do?
Every investor is in a different set of circumstances.
Generally our investment approach has been to remain on the conservative side of industry standard asset allocations for each risk profile. But our clients hold equities either directly or within managed funds. And according to history those assets could fall further yet.
The last 14 post war bear markets in the US have lasted on average, 12 months. Leaving aside the 2020 plunge, the previous big recession related downturn in 2007-2009 lasted 17 months. March 2000 was another market peak, and it took 28 months to wash out that overvaluation while the S&P500 declined 44%.
On 31 December 2021 the S&P500 had its highest ever weekly close at 4766. On Friday June 17th 2022 the S&P had its lowest weekly close this year at 3674, down 22.9% over slightly less than six months.
In that context, do I think the markets could have further to fall?
Combined with the probability that central banks are painted into a corner where they have to keep raising interest rates and where the odds of bad economic news are increasing, and where company profits are likely to be squeezed by both falling discretionary spending and rising input costs, I have to say YES.
While it is relatively easy to make a decision to sell after a market has fallen substantially, the mental game of where and when to get back in is often underestimated. The best time to re-invest will never look like a good time to invest.
This is our call to investors to think about the level of risk they are comfortable with. If you are uncomfortable with the level of risk or are unsure about anything in your portfolio, we ask that you get in touch to schedule a discussion or an out of cycle review. As we do our reviews we will be looking at any assets that should be trimmed or replaced.
We do see lots of assets that appear to be good value at the current levels. This is where it becomes a tug-of-war between the bottom up and top down views. I have been averaging down into some of my favourite companies and trusts, but I also have in mind those historical bear market statistics that make me pause before committing all of my capital.
Stay safe and diversify!
Wow really interesting analysis