Multi Asset: Everyone has a plan until they get punched in the mouth

On the Mark – Multi Asset Strategy - June 2022

‘Everyone has a plan until they get punched in the mouth’ – Mike Tyson.

• Markets decline aggressively.

• What type of recession?

• Negative sentiment & positioning but there are complexities.

This year has started with a lot of records and none of them make pleasant reading at the halfway stage. Below, we go through a few of the most striking.

• The S&P 500 peaked on the first trading day of the year and has fallen just over -23.0%.
• The S&P500 finished the first half off the year with the worst start to the year since the early 1970’s and the fourth worst on record.
• When adjusted for inflation this was the S&P500’s worst stretch for real returns since the 1960’s according to Jim Reid at Deutsche Bank.   
• The S&P fell -16.5% in Q2, the 18th worst on record.
• The Russell 1000 Growth Index had its worst first half versus the Russell 1000 Value Index since 2002.
• The Nasdaq Composite fell -29.5% in the first half which was its worst start to the year since data began in 1972.
• US Government Bonds had their worst start to the year since 1788 according to a calculation by Deutsche Bank, who cited an unconventional index from global financial data which uses proxies for 10-year US debt.  
• The Bloomberg Global Aggregate ex China was down
• This was the worst first half of the year, in modern history for long term treasuries and Investment Grade credit.
• In Q2 US High Yield plunged an awful 9.8% only beaten in 1990, 2008 and 2020.  
• Over the last six months more than 90% of assets tracked by Goldman Sachs underperformed cash.  

Unfortunately, the list could go on… Only a few commodities markets and stock market indices with heavy weightings to commodity stocks, such as FTSE100, have held up in H1 2022.

It has been disastrous for traditional balanced or 60/40 portfolios, with such US accounts posting their worst performance since 1932. In the UK, investors have been bailed out by Sterling’s dismal drop of over 10% against the US dollar, which converts into a major mitigation of losses.

We presume you have got the message – it has been awful, and few predicted such an outcome with a notable exception: M. Wilson at Morgan Stanley; more from him later.

So, where are we now? This is an obviously common question and here are a few of our thoughts.

The good news is that equities tend to rally after such awful starts. Ned Davis Research (NDR) state that ‘In the 19 previous times the S&P 500 fell at least 15% in a single quarter, the next quarter it rebounded 68% of the time by a median of 6.8%. Since WWII, it has risen seven out of eight times, with the one exception being Q1 2009. Two quarters later, the S&P 500 has been up 100% of the time by a median of 13.0%. One year later, the stats are 100% of the time and a 25.1% median gain’.

NDR’s conclusion is as follows: ‘History suggests that unless the economy is in a deep recession, the stock market should rebound in the second half.’

Let us take a look at how things are developing on the US economy, in particular on employment.

We have been emphasising for some time that this recovery has numerous unusual features that will puzzle economists and market participants. The focus of our attention was drawn to the potential threat of sustained inflation transmission through the dynamics of employment and wages.

It should be fairly evident to most observers that we are now facing a US recession with many data points contributing to the picture of a deteriorating outlook. These include an inversion of the US Treasury yield curve (at the short end as well as at 2 years minus 10 year). The Atlanta GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2022 now -2.1 percent on July 1 (Figure 1).

Figure 1. Evolution of Atlanta Fed GDPNow real GDP estimate for Q2 2022.

Source: Federal Reserve Bank of Atlanta, Blue Chip Economic Indicators and Blue Chip Financial Forecasts.

So, what should we expect to see in the employment numbers in the typical recession cycle?

Goldman Sachs show that in the median advanced economy recession since the 1960s the unemployment rate has risen by 2.7% (Figure 2).

Figure 2. Median change in unemployment rate during recessions since 1961 (Trough to Peak.

Source: Haver Analytics, Godman Sachs Global Investment Research.

Simon Ward at Money Moves Markets shows that we are now on the path to finding out how bad things will get. As Ward states “A further softening of jobs responses would support other evidence (eg., a rise in involuntary part-time working) that unemployment is about to head higher”. (Figure 3.)

Figure 3. US unemployment rate & consumer survey labour market indicator/Involuntary part time working. 

Source: Simon Ward at moneymovesmarkets.com

Whilst this view can be considered the most likely scenario, it is evident that there are multiple cross currents at play which complicate the picture.  

Rattled by the most recent wave of strict Covid lockdowns in China, the long-time manufacturing hub of choice, CEOs of multinational companies have been highlighting plans to relocate production onshore at a greater rate this year than they did in the first six months of the pandemic, according to a review of earnings call and conference presentations transcribed by Bloomberg. More importantly, there are concrete signs that many of them are acting on these plans (see Figure 4). This would lead to marked employment opportunities and a significant lessening of any recessionary effects.

Figure 4. Factory Building Boom.

Source: US Census Bureau, Bloomberg.

As a result, for some investors, talk of recession is premature as hiring remains robust. Nonfarm payrolls expanded by 372,000 in June, well above the consensus of 265,000. The employment diffusion index picked up to 68.6% from 67.0% in the previous month, while its 12-month average posted its highest level since March 1998. Such broad-based industry participation reflects continued strong labour demand.

However, we see this as all part of the unusual nature of the economic shutdown and reopening, which is creating great difficulties in how to price outcomes.  The following chart (Figure 5) was published by Deutsche Bank may offer some further insight into a key question.

What type of recession might unfold?

The chart could be showing us that we are about to enter a period where the normal relationships hold, and unemployment will rise very sharply? But what if this is an example of non-cyclical divergence as we suspect.

Could we get a recession without a typical rise in unemployment?

Figure 5. US Consumer Sentiment vs. Unemployment Rate – a huge decoupling

Source: University of Michigan, BLS Haver Analytics , Deutsche Bank.

As we have stated on previous occasions, bear markets associated with hard recessions are generally more drawn out and deeper – this chart from NDR is a nice graphical representation but more evidence on this effect can also be found from other research sources.

Figure 6. Bears longer and more sever when overlap with recession

Source: Ned Davis Research

One of the most prominent forecasters of this bear market, M. Wilson of Morgan Stanley, warns that earnings remain too high even in the soft-landing outcome. Under that scenario, he thinks Next Twelve Months Earnings per Share should fall toward $225-230 over the next few quarters. Using that as his guide, Wilson looks for a fair value target of approximately 3400-3500 on the S&P 500. This would be in line with the typical experience encountered in a recessionary environment.

In conclusion there are so many new and unusual features of this cycle that do not tally to the “typical” cycle, meaning there is now a lot of room for error. Investigation of the detail is once again critical and perhaps, just perhaps active managers may have entered a period that will offer them more rewards!

Mark Harris
Fund Manager, Multi Asset