From Liquidity to Fundamentals
What this research paper is about
Despite various challenges (first and foremost the 2½ year old COVID-19 pandemic), equities have delivered extraordinarily attractive returns in recent years; in fact, so attractive that annual returns have far exceeded what equity investors can reasonably expect. Those returns have been particularly attractive in the US, but many other countries have participated in the party as well.
When looking for reasons why equities have been able to climb the wall of worry so successfully, it is pretty obvious that remarkably benign liquidity conditions provide the answer. A combination of unusually low interest rates, plenty of quantitative easing and various other stimulative monetary initiatives have created unusually benign conditions for equities.
Unfortunately, this has led to equities becoming uncomfortably expensive, and the implication is that when the liquidity-driven bull market comes to the end of the road, and fundamental factors begin to drive markets again, equity markets become very sensitive to bad news. In this research paper, I will argue that we have now reached the point where fundamental factors have begun to take over again, and I will argue that, at the very least, an earnings recession is around the corner – quite possibly even a full-fledged one.
You may recall that, earlier this year, I raised the probability of a US recession to unfold in 2022-23 to 67%. At the same time, I raised the probability in the UK and the EU to 75%. Today, those numbers are raised to 75% and 90%, respectively.
A quick recap of equity valuations
When you compare equity valuations over time, you need to adjust for the fact that you may be at different stages of the economic cycle. That is accomplished by using the CAPE ratio (the cyclically adjusted P/E ratio) rather than the vanilla P/E ratio. The methodology was developed by Professor Robert Shiller, hence why the CAPE ratio is often referred to as the Shiller ratio.
As of the 19th of August, the S&P 500 CAPE ratio was 31.2. As you can see in Exhibit 1 below, the sell-off earlier this year reduced the overvaluation vis-à-vis the modern-era average of 19.6 from nearly 100% to about 45%; however, the summer rally has increased the level of overvaluation again, which now stands at almost 60%.
As you can also see, today’s valuation puts the current CAPE multiple 1.4 standard deviations above the modern-era average. Since 1950, only twice has the US equity market been more expensive than it is now – during the internet bubble in the late 1990s and during the present ‘everything’ bubble last year.
Given the current level of overvaluation, US equities are susceptible to a material worsening of economic conditions. Yes, it is indeed correct that other stock markets around the world are not nearly as expensive as the US market is (see for example here); however, the US equity market is the global bellwether and, when US equities struggle, so do virtually all other equity markets around the world. Therefore, if the outlook for US equities is rather dire, conservative investors should be cautious worldwide.
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Is a recession around the corner?
Allow me to begin by reminding you of the drivers of GDP growth:
GDP = C + I + G + (X-M)
In other words, GDP is the sum of consumer spending (C), investments (I), public spending (G) and net exports (X-M). In most developed countries, and that is particularly the case as far as the US is concerned, the C in the equation carries the biggest weight, i.e. if the consumer holds back on spending, the economy is in trouble.
Inflation enters the frame when measuring the change in economic output from one period to the next (Change in GDP), which is typically measured in real (inflation-adjusted) terms. Inflation in most counties is now higher than it has been for about 40 years. Take for example the UK, one of the worst affected countries worldwide (Exhibit 2).
The latest inflation report from ONS in the UK suggests that consumer price inflation (CPI) now stands at 10.1%. As you can see above, the Bank of England now predict that number to rise to 13.3% by October, at which point it will start to decline (they say); however, several research firms disagree. Take for example Citi, the current frontrunner on pessimism. They believe inflation won’t peak until January 2023, and that CPI in the UK will be 18.6% by then. A recession is virtually inevitable if those sorts of numbers are correct.
Apart from a dire inflation outlook when looking into late 2022 and early 2023 (primarily caused by exceptionally high energy prices), the C and the I in the GDP equation above also look vulnerable. Take for example the outlook for US consumer spending. As you can see in Exhibit 3, US consumers increasingly struggle to pay off their credit card debts, and the excess savings raised during the early stages of the pandemic are vanishing fairly rapidly.
Likewise in the corporate sector. The PMI index is usually a solid leading indicator of future economic growth and, as you can see in Exhibit 4, US PMI (the green line) now suggests a meaningful decline in output (the white line) later this year.
As a consequence of the dire outlook, I raise the probability of a US recession to unfold in 2022-23 from 67% to 75%, and I raise the probability in the UK and the EU from 75% to 90%. In other words, a UK and an EU recession is now almost a given whereas, in the US, there is still a modest chance of escaping one.
If a recession does hit the global economy later this year or early next, and it is increasingly difficult to see how we can escape this one, the villain is pretty obvious – grotesquely high energy prices, mostly (but not exclusively) caused by Putin’s antics. With energy prices at current levels, many households will struggle to make both ends meet when we begin to heat our homes again. Manufacturers are already battling with punishing energy costs.
As you can see in Exhibit 5 below, Germany – the manufacturing powerhouse of Europe – is experiencing an extraordinarily high rise in producer prices. Given the close link between PPI and CPI, CPI can only rise further in Germany in the months to come. If the German economy goes down the drain, so will most of Europe.
Higher gas prices are the culprit, partially because many homes in Europe are heated by gas, and partially because many European power plants use gas (much of which is imported from Russia) when generating electricity. Consequently, electricity prices have reached absurd levels in most of Europe (Exhibit 6). The average European electricity price in the second semester of 2019 (i.e. just before the pandemic) was €78 per MWh. As you can see below, the price is now over €600 per MWh in many European countries.
US electricity prices and US gas prices are both comparatively low and, for that reason, the damage to the US economy from high energy prices is less dramatic. The electricity price averages about $104 (€104) per MWh at the moment (with significant variations from state to state), i.e. Americans pay dramatically less for their electricity than we do here in Europe. This will not completely protect the Americans from recession, but it will make one less likely.
When the US Congress passed President Biden’s Infrastructure Law earlier this summer, it also ensured that the G in the GDP equation above will grow quite handsomely for many years to come. For that reason, if for no other reason, the US stands a reasonable chance of staying clear of the brewing recession.
However, from an investment point-of-view, the most relevant question is not whether we’ll have a recession or not, but whether we’ll have an earnings recession, and that will be hard to avoid, I believe. The combination of punitive energy costs and soaring wages will force companies to raise prices to protect their margins, and sluggish consumer demand will most likely cause consumers to reject those price increases.
Therefore, companies all over the northern hemisphere face a very challenging 6-9 months, as households are forced to spend far more than they normally do to heat their homes. Consequently, I think an earnings recession is almost a given. So far, US investors have chosen to largely ignore that. As you can see in Exhibit 7, US equities have outperformed equities in the rest of the world by almost 20% over the past couple of years, leading to US earnings multiples being worryingly high, as referred to earlier. Precisely for that reason, I would expect an earnings recession to do more damage to US equities than to non-US equities, assuming the earnings recession is global.
Exuberant investor behaviour is found all over the world, though. Let me give you one example. As you can see in Exhibit 8 below, European cyclicals underperformed European defensives earlier this year (as they should), as it became increasingly clear that a European recession was on the horizon. However, as you can also see, cyclicals have outperformed defensives in the summer rally, and that makes absolutely no sense unless a recession in Europe is suddenly less likely.
Going into the 2022-23 winter season, I have established five rules, which will form the essence of my portfolio advice:
1. Keep the equity beta in your portfolio well below 1.
2. Do not use any leverage.
3. Underweight US equities relative to equities in the rest of the world.
4. Do not underweight equities in general (bonds are not any better), but increase your allocation to investment themes which are virtually set in stone – recession or not.
5. Increase the allocation to EM equities if, but only if, the US dollar stops rallying. Many EM countries are less sensitive to rising gas prices but very sensitive to a strong US dollar.
Final few words
Just one additional comment from me today. You may wonder why I don’t offer a few more details on the five rules just mentioned. As it happens, I will provide much more information on those rules in our autumn webinar, which is set for the 15th of September at 15:00 BST. You will receive a formal invitation next week. If the topic is of interest to you, please mark your diary!
Niels C. Jensen.
26 August 2022