The fight against inflation has already led to outsized interest rate hikes by central banks in major economies, and further hikes are foreseen in the coming months.
The likelihood of a global recession is increasingly unavoidable and higher borrowing costs and high energy prices as a result of the Ukraine conflict, will hit hard.
The ratio of spare capacity to employment in the US tends to lead the US yield curve at major turning points in the business cycle.
Since December, 2021the ratio is testing the lows that occurred before the 2000, 2008 and 2020 recessions. Yes, the US economy was running at full capacity.
With near full employment in the US and elsewhere, it means that business will be reluctant to expand. Capital goods orders are likely to come under pressure. Company profits will come under pressure and jobs will be lost.
Spare capacity will be rising faster than employment and the ratio of spare capacity to employment in the US will therefore jump. Value destruction on equity and related markets are likely to remain on the radar screen.
But what does the market say?
The current bear market in equities is already two quarters old. According to sources, the historical average bear market lasted about three quarters in the past but it can take three to four years to get back to the top.
The 12-month momentum of the MSCI Consumer Discretionary Index relative to the MSCI Consumer Staple Index leads the momentum of OECD industrial production by about five months, and indicates a drawdown of about five to 10 percent in industrial production by the final quarter of this year.
This is confirmed by the weekly smoothed annualised growth rate of the MSCI All Country World Index in US dollar (ACWLD$) that tends to lead the average official manufacturing purchasing managers’ indexes of China (CFLP measurement) and US (ISM measurement) – the two major economies – and indicates a contraction in global manufacturing output in the coming months.
My biggest concern is the decoupling of consumer sentiment as measured by the University of Michigan, and stock market valuations as measured by Nobel Laureate Robert Shiller’s PE10 (price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years) since the outbreak of Covid-19 in March, 2020.
Consumer sentiment is within a whisker of touching the lows of the 2008/9 global financial crisis (GFC) and Black Monday in August, 2011 following the first time in history that US sovereign debt was downgraded.
In the four years following the 2008/9 GFC, the S&P 500 Index traded in a narrow band around 15 times forward earnings.
Excluding the impact of Covid-19, the index rerated to about 20 times forward earnings but according to various publications, the drawdown since December last year saw the S&P 500 currently trading at about 16 times forward earnings.
My concern is the earnings growth forecast of about 11 percent for the next 12 months could be scaled down should the US and rest of the world slip into recession.
The major market players have already priced in a much weaker economy or even a recession.
The 12-month momentum of consumer discretionary stocks relative to consumer staple stocks is at minus 22 percent, and fast approaching the lows of about 30 percent last seen in 2002 and 2008.
The relative under-performance of consumer discretionary stocks from here on, may not be just a dip and could last longer similar to the six months or so during the global financial crisis in 2008/9.
The conflict in Ukraine has thrown a spanner into the works as nobody except President Putin knows what Russia’s end-game is. Aptly summarised by Tadeu Marroco, finance and transformation director at British American Tobacco’s 2022 First Half Pre-Close Conference: “… This conflict is increasing global uncertainty and disruption, further exacerbating inflationary pressures on supply chains, impacting consumer consumption and resulting in increased finance costs.”
The depth and duration of recessionary conditions together with the impact of the Ukrainian conflict on various countries and economic zones will determine how their central banks react.
Normally in a recession, the yield curve bottoms – currently the US yield curve is flat – and starts to rise as shorter-dated government bond yields fall below longer-dated bond yields, as the credit markets start to price in lower inflation and abatement of further rate hikes.
Any sign of dovishness by central banks will boost consumer discretionary stocks at the expense of consumer staple stocks, and confirm the start of a new bull market in equities.
Tread carefully, though. The stock market is forward-looking and may bottom some time before central bankers turn dovish.
Some consumer discretionary stocks are already offering exceptional value but do not throw caution to the wind.
I’d rather buy the trough and not the dip.
* Ryk de Klerk is analyst-at-large. Contact [email protected] He is not a registered financial adviser and his views expressed above are his own. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.