Friday 22nd July 2022
Is all the bad news factored-in?
With this week's worse-than-expected inflation numbers, all eyes are centred on the Federal Reserve, which is now expected to hike rates even more aggressively.
With this week’s worse-than-expected inflation numbers, all eyes are centred on the Federal Reserve, which is now expected to hike rates even more aggressively. But on the flipside, such aggressive hiking of rates will surely put US economic growth at risk, and may cause a hit to earnings.
In the latest Anatomy of a Recession update, investment strategist Jeffrey Schulze, from ClearBridge Investments (owned by Franklin Templeton), examines the current state of the US economy together with rising inflation and corporate earnings, and concludes that a recession does not appear imminent.
Schulze points to a key question that should be asked: is all the bad news factored-in? If history is anything to go by, the market will need to digest the latest inflation figures, which have undoubtedly sent markets lower. Data suggests that this bear market might have another seven months to run. The non-recessionary bear market average is 13 months, with a -28.2 percent drawdown. The current bear market has run six months, with a 23.6 percent drawdown.
The second thing to factor-in is P/E compression. Most bear markets are kicked off by declining P/Es. The current bear market has had its P/E fall from 21.3x at the start of the year, to 15.8x today.
Schulze says, “The second leg of most bear markets features earnings contraction. The current bear market has been entirely driven by P/E compression, while forward earnings expectations have risen by a healthy 7.4% this year. In the last two weeks, earnings revisions have started to drift lower, and we see a strong possibility of more meaningful downward revisions as we move through the back half of the year. Ultimately, the degree to which earnings expectations decline will determine the degree of the economic slowdown.”
However, where equities bottom, Schulze says, “will depend on just how well the economy holds up and in turn where earnings head. With inflation remaining elevated and maximum employment achieved with unemployment below 4%, the Fed is increasingly fearful of inflation expectations unanchoring.”
The Fed is far more fearful of doing too little to tame inflation than doing too much. In the end, Schulze says, “recessions are like death and taxes: they can’t be avoided forever.” While one doesn’t appear imminent based on the ClearBridge Recession Risk Dashboard, some worrying signs indicate a weakening economy. These include softening of commodity prices, retail sales and money supply.
Schulze’s message is that a market bottom will only be known in hindsight, but its visibility will improve. When it becomes obvious, equities will have already rebounded from its lows. While bear markets are rare, they provide an excellent opportunity to capture great companies at beaten-down prices.
Ishan is an experienced journalist covering The Inside Investor and The Insider Adviser publications.
