Above The Noise: Same song, new verse

Key takeaways

How do you define a recession?
I’ll stick with this definition: A significant decline in economic activity that is spread across the economy and lasts more than a few months.

How much more could stocks fall?
I look at stock performance in past recessions for clues as to how much stocks may fall if we do enter a recession.

Insights into high yield.
I share three key takeaways from our recent podcast with Niklas Nordenfelt, Head of High Yield for Invesco Fixed Income.

Welcome to the first edition of Above the Noise, a monthly commentary designed to provide context and clarity to the latest macro and market events shaping the national conversations. This column will provide you with our views on the great debates of the time, the opinions that have us scratching our heads, the frameworks and data that are guiding our views, the answers to pressing questions, and more.

Along the way, we’ll try our best to have some fun. Special thanks to internet journalism trailblazers such as Bill Simmons and Peter King who provide some of the inspiration for the framework. You know what they say about imitation and flattery, although I’ll try to not be the mediocrity to their greatness. Everyone borrows anyway. It’s like Krusty the Clown said, “If this is anyone but Steve Allen, you’re stealing my bit.” Thanks for reading. I look forward to engaging in a long-lasting conversation that stays above the commotions of the day.

Once-popular culture reference of the month

The first 30 weeks of the year reads like a Billy Joel song:

Inflation moving way too high, zero COVID in Shanghai
Policy is getting tight, BoJo ends his PM fight
Pandemic has a new strain, Russian troops in Ukraine
The Fed needs to put out this fire

Ok, I’ll stop. That was terrible. But you can’t blame investors for wondering how much more can be thrown at them. Add in recession fears and an upcoming midterm election and it’s no wonder that investors’ nerves are tattered. Nonetheless, recent weeks (including the full month of a July) is reminder of the challenges of trying to time these markets. A few pieces of better-than-expected news and the market recovered a decent amount of the ground lost this year. The latest bounce may not prove to be an all-clear signal for investors but was nonetheless a welcomed respite.

A ‘keep it simple’ strategy

No matter what’s going on in the world, there are three critical questions that can help us gauge the potential impact on markets. How would I answer these questions today?

1. Where are we in the cycle?
   The risks to the cycle are elevated. Cycles tend to end with policy tightening and inverted yield curves. We ignore the bond market at our own peril.
2. What’s the direction of the economy?
   The slowdown is moving into a contraction, as leading indicators suggest that growth may be below trend and falling.¹
3. What is the expected policy response?
   Tighter, although July’s better-than-expected Consumer Price Index report² and the rapid decline in inflation expectations³ may leave open the possibility of the Federal Reserve moderating its tightening stance later this year.

The upshot? We would still favor a more modest risk profile and a more defensive posture, as well as quality bonds and businesses that can generate cash flow and growth in a slowing environment.

The national conversation

How do you define a recession?

Option 1: “Two consecutive quarters of negative gross domestic product growth!”

Option 2: “A significant decline in economic activity that is spread across the economy and lasts more than a few months!”

I haven’t seen a debate this divisive since the old Miller Lite commercials presented us with a choice between “Tastes Great” and “Less Filling.” I wish we still had George Steinbrenner and Billy Martin or Bob Uecker and Bubba Smith with us to fight this out.

Candidly, I don’t know where the “two consecutive quarters of negative growth” definition originated. It’s been a good rule of thumb over the past 50 years. However, last quarter’s decline was driven by a large inventory swing as businesses, in prior quarters, had already feverishly worked to restock their shelves.⁴ That’s hardly a broad decline across wide segments of the economy. I’ll stick with the “spread across the economy” definition, used by the National Bureau of Economic Research. By that definition, I’d have a hard time arguing that the US is in a recession yet. Just walk by a restaurant or try to get a hotel room.

It’s probably all semantics and cold comfort to investors anyway. The market is already down 23.4% from the recent peak to the current trough.⁵ Call it what you want. Either way, to borrow from another past beer campaign, it’s left investors with a case of “bitter market face.”

It may be confirmation bias, but …

… inflation is cooling:

• Container freight rates are down over 35% in the past 10 months.⁶
• Lumber prices are down over 40% in the past four months.⁷
• Gasoline futures are signaling that the national average of prices at the pump are expected to fall below $4.00/gallon.⁸
• Select retailers are reporting inventory overhangs.⁹
• The bond market’s expectations for inflation in the next year fell from 6.3% in March to close to 3% on August 10.¹⁰

Since you asked

If there’s a recession, how much more would the stock market decline?

• The average peak-to-trough decline associated with the past 10 recessions is 31.9%.
  • That includes more mild recessions such as 1980 and 1991 when the market fell by 16% and 20%, respectively, and more severe recessions such as 2008 when the market fell by more than 50%.¹¹

• The median decline associated with recessions is 22.7%.¹¹

That should help to put the recent 23.4% decline experienced from Jan. 4 to June 16 into perspective.¹² It’s already worse than the median return associated with recessions and roughly 3/4ths of the way to the average.

Phone a friend

I phoned my colleague Talley Leger, an Equity Strategist at Invesco, for additional thoughts on this most pressing question. His response:

“I broadly agree. My base case is that the Fed will induce a short recession. However, I think the impact on stocks will be relatively mild, given how much they’ve already fallen. Recall that market cycles lead economic cycles, not the other way around. Stocks may some more work to do to complete their bottoming process however, I do believe that the bottoming process has begun. The sequencing starts with a rally in the government bond market, which is supposed to be one of the safest places for an investor to put their money. In turn, a lower discount rate raises the present value of expected corporate cash flows, which ultimately may help riskier assets like stocks to find a bottom. So far, so good.”

It was said

“… we’ve been saying we would move expeditiously to get to the range of neutral. And I think we’ve done that now … I think the committee broadly feels that we need to get policy to at least a moderately restrictive level.” – Jerome Powell, Fed Chair¹³

“(the Fed) has a long way to go. We are still resolute and completely united.” – Mary Daly, San Francisco Fed President¹⁴

Moderately restrictive and a long way to go. As Tupac sang, “Clear enough for ya?” Market volatility is almost always the result of policy uncertainty. Alas, policy clarity continues to elude us, even with July’s better-than-expected Consumer Price Index report. Let’s characterize the latest inflation data as welcomed but not sufficient.

Everyone gets a podcast!

In case you missed it, Niklas Nordenfelt from the Invesco High Yield Bond Team was a recent guest on the Greater Possibilities podcast, which you can listen to here. Here are the takeaways from the mind of Niklas:

1. He believes current yields are already providing enough “cushion,” meaning the market is already pricing a mild recession.¹⁵
2. Corporate fundamentals are sound, in his opinion. He believes leverage ratios are healthy and income coverage ratios are nearly as good as they get.
3. Investors do themselves a disservice in trying to time the high yield bond market, in his view, as most of the return over time comes from the income. Nonetheless, he believes now appears to be a good entry point and investors should be prepared to add to their position should prices deteriorate further.

On the road again

I only had to travel to West Orange, NJ, to hear Mike Eruzione deliver a keynote speech to investment professionals. My biggest takeaway from Eruzione’s speech is that the captain of the 1980 US Olympic Hockey Team does not believe that the Miracle on Ice was in fact a miracle. Rather, it was a team that believed in working hard, believed in sacrifice, and believed that anything can happen. He was inspiring, and more importantly he couldn’t have been a nicer guy. Sometimes, it is good to meet your heroes.

Having started with Billy Joel, I’ll conclude with The Happenings: See you in September.

Enjoy the rest of the summer.

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