Do You See "Roses" or Thorny Recessions?

Do You See "Roses" or Thorny Recessions?
Jake and Tim recap some highlights and key thoughts from this week’s Quarterly Event and our special guest presenter.

Five Things You Should Know

1. Equity Markets – were lower this week with U.S. stocks (S&P 500) down -0.95% while international stocks (EAFE) fell -1.50%.
2. Fixed Income Markets – were higher with investment grade bonds (AGG) up 0.98% while high yield bonds (JNK) rose 0.69%.
3. Fed Considers Historic Move – after news broke this week that inflation hit a new 40-year record of 9.1% year-over-year in June, debate amongst Fed officials have begun on whether a historic 100-basis point rate hike later this month makes the most sense for the economy. Cleveland Fed President Loretta Master was quick to suggest a 75-basis point hike should be considered the minimum, while Federal Reserve Governor Christopher Waller held firm in his belief that the next hike should remain at 75-basis points.
4. Dollar Finds Parity – for the first time in 20 years, the U.S. dollar and the Euro have reached parity (the exchange rate between the two is 1 for 1). The Euro has seen significant weakening in recent months due to unfavorable interest-rate differentials, Europe’s energy crisis, and an overall weakening economy. A wearing currency may continue to drive record inflation in the Euro area.
5. Key Insight – [VIDEO] Jake and Tim recap some highlights and key thoughts from this week’s Quarterly Event and our special guest presenter. [ARTICLE] Big inflation data and moves in Treasury yields brought out the doomsayers yet again. Is the resulting pessimism justified or could it be overdone? We look at some key points you likely won’t see in the news.

Insights for Investors

“We can complain because rose bushes have thorns or rejoice because thorns have roses.” ― Alphonse Karr

Intro – Pessimists Abound

Look at any sentiment indicator and you’ll see historic levels of pessimism, though a simple glance at the news or coffee shop conversation would perhaps be just as effective at understanding the collective mindset of investors these days. In short, most people are focused on the thorns and looking past any roses that exist.

Is it justified? In part sure, there are a lot of troubling things in today’s world.

However, one should/could also ask themselves questions such as:

• Is this without precedent?
• Aren’t there always troubling realities in the world?
• Have markets/economies not shown ability to overcome such challenges?
• With almost a 20% sell-off, has the market not priced in a lot of bad news?
• What type of timeframe should I view my investments through?
• Do I truly have insights into the future that would improve my “odds” over following time-tested principles?
• Are there any reasons to believe the pessimism is overdone?

If one is honest, after reflecting on the above, they will likely conclude that while things may be frustrating and even frightening, their alternative courses of action are fraught with at least as much potential peril and potential losses over time.

Furthermore, there are several “roses” that could begin to bloom at any moment.

recession vs. RECESSION

As we tried to emphasize in the last few week’s commentaries, recessions do not come in just one form, let alone usually one that looks like a 2008 style recession. You wouldn’t know this from how people use the term these days to scare others, but the truth is some recessions are merely technical while others are tyrannical.

If one looks at the critical labor market if a recession does lie in our near future, it looks far more like the former than the latter – an outlook JPMorgan’s recent report noted as well.

JPMorgan summarized it this way, “The June jobs report painted a picture of consistency and strength in the labor market. The U.S. economy added 372K new jobs, remaining in line with the 383K average monthly gain over the past 3 months. Job growth was widespread, boosted by education and health services (+96K), professional and business services (+74K) and leisure and hospitality (+67K.). We also saw employment in manufacturing (+29K) return to its pre-pandemic levels. The unemployment rate extended its streak of 3.6% for the fourth consecutive month as the number of unemployed Americans stayed nearly unchanged at 5.9M. The labor force participation rate also remained quite steady at 62.2% vs. 62.3% in May. Wage growth continues to cool modestly with average hourly earnings rising by 0.3% after a 0.4% climb last month.

At a time when recession speak dominates investment conversations, the consistent strength in the U.S. labor market should be viewed as a bright spot. It is an important tailwind for the U.S. economy against the risks of hotter for longer inflation and falling consumer sentiment. It is also worth noting that since employment is a lagging indicator, the June jobs report does not eliminate the risk of a recession starting soon. However, with such robust labor demand, it does suggest that the next economic downturn could be a relatively mild one for American workers.”

This week’s latest employment data with continuing jobless claims falling 41,000 to 1.331 million lends further support to healthy job growth undergirding the economy at this time.

Despite some of the headline click-bait spins on JPMorgan CEO Jamie Dimon’s thoughts this week, he would seem to agree that fears for a “tyrannical” recession are largely unfounded despite the issues facing the economy. This is primarily due to his view that, “the consumer right now is in great shape. So even if we go into a recession, they’re entering that recession with less leverage and in far better shape than they did in ’08 and ’09.”

Similarly, Morgan Stanley CEO James Gorman stated that while issues exist, they are not “2008 complicated.”

Does this mean “the bottom is in”? Of course not, but there is good historical reason to believe we could be close as pointed out by Goldman Sachs this week discussing their research into typical market drawdowns during most recessions.
They noted, “Aggressive Fed policy action has driven the majority of US equity market contraction to date. While calling the market bottom remains challenging, history suggests that monetary policy-induced recessions have seen peak-to-trough S&P 500 drawdowns of -22%, on median. Though no two tightening cycles are the same, we believe today's starting point of macro strength may moderate further equity downside as rates begin to stabilize.”

Data and History Lend Further Weight to a Constructive Outlook

Former fund manager Scott Grannis highlighted another likely cause for the market’s recent stabilization stating, “The market is now beginning to look across the valley of still-high inflation this year to the other side when inflation news will start improving. Markets are good at reading the inflation tea leaves; if only politicians were so smart.”

He went on to add to his argument noting, “Thanks to the introduction of TIPS (Treasury Inflation-Protected Securities) in 1997, we have a direct reading of the bond market's inflation expectations for coming years. It's called the Breakeven Inflation rate, or the rate which will make you indifferent to holding nominal T-bonds or TIPS (and calculated simply by subtracting real rates from nominal rates). The bond market now expects the CPI to average 2.5% a year over the next 5 years, and that's down sharply from an all-time high of 3.6% registered in mid-June. Wow.

Consistent with the improvement in the outlook for inflation contained in these charts, the bond market has adjusted downwards, by a whopping 100 bps, its expectation of the Fed's target rate at the end of 2023 (was 4%, now 3%).

All good news, of course, especially since it means the risk of recession (typically brought on by a punishingly tight Fed) is likely lower than the broader market thinks. And it's a clear message to the Fed that they needn't (and definitely shouldn't) panic and raise rates too much or too fast.”

Where is this hope of a moderating inflation coming from after a 9%+ CPI report?

Of late, from all over. The cost to move freight that was $20,000 a container a few months ago is now $7,000 as the supply chains clears, rents actually declined in June as did used car prices, and of course most critically, the price of oil has now returned to pre-Ukrainian war levels (see chart below).

So, while inflation is still running hot in terms of the most recent data (e.g., this week’s Producer Price Index coming in up 11.3% versus one year ago and Consumer Price Index up 9.1%), those numbers reflect energy increases of 10%, and that catalyst will likely abate in future readings given the recent drop in oil prices.

Another explanation as to why markets initially sold off on the inflation report only to subsequently stabilize and rally were summarized wonderfully by Tom Essaye who explained, “Taken in the context that the S&P 500 is already down about 20% YTD, the market essentially viewed the hot CPI report just reinforcing what it already knew: 1) Inflation hasn’t peaked yet but there are signs it’ll peak soon, 2) The Fed won’t hike any more than currently expected (it may hike faster, but the end result should be the same) and 3) That the slowing economy will stay the Fed’s hand on rate hikes later in 2022 or early 2023, and in a year or so we’ll be talking about rate cuts.”

Another important reason was highlighted by Scott Grannis who pointed out the meaningful slowdown in M2 monetary supply (cash and cash equivalents in the system) which, after spiking due to the various COVID measures implemented by governments since 2020, has not grown for five months and counting. He concludes that consequently CPI will likely fall soon and, “that the Fed won't need to tighten dramatically or strangle the economy, as it has in the past” rather, “the economy is likely going to survive this bout of inflation without serious consequences. It will be painful for many, to be sure, but the economy needn't collapse.”

Just When It Seems Winter will Never End…

When things are really good or really bad it’s hard to believe they will ever change. And yet, history (and life experience) should remind us that while those feelings may be strong, the probability that they are true is not.

So here we sit after one of the worst quarters for the S&P 500 on record, and many understandably expect more of the same, but similar market drawdowns suggest the market will once again surprise many investors.

Take a look at the chart below showing market returns after similarly bearish quarters.

A related point from Bespoke shows that, “Following prior 20%+ two-quarter drops, the S&P has averaged a gain of 8.51% in the next quarter, a gain of 21.47% over the next half-year, and a gain of 31.36% over the next year. Looking specifically at next-year performance, the S&P has been up 7 of 7 times in the year following 20%+ two-quarter drops. The strongest next-year gain was the 46.57% rally following Q1 2009. The weakest next-year move was the 22.16% gain following Q3 2002.”

In Summary

It has certainly been a painful start to the year, and while the “thorns” in the economy’s side hurt, they are not fatal, and the truth is that just like a rose bush, thorns of some form always exist. However, so do the “roses” and resilience of markets.

The choice of what you decide to see is yours.

And of course, any time you are struggling to see past those thorns please give us a call. We are always happy to talk with you.


Have a wonderful weekend,

Tim and the team at TEN Capital

Data, Just the Data

Data points this week included:

• U.S. Jobless Claims – jumped by 9K to 244K claimants in the week ending July 9^th. This is the highest claimant count since November 2021 as job cuts and economic uncertainty start to creep into the labor market. The four-week moving average moved up 3.25K to 235.7K.
• U.S. CPI – edged up to 9.1% YoY in June 2022, the highest rate since 1981 and a boost from the 8.6% reading in May. Energy prices increased to 41.6% with gas rising 59.9% (highest since 1980), and electricity expanding 13.7% (most since 2006). Food costs also rose 10.4%, and the core inflation rate moved up 5.9%, slightly below last month’s reading of 6%.
• U.S. PPI – expanded 1.1% MoM in the month of June, the most in three months and slightly higher than last month’s reading of a 0.9% increase. Goods prices rose 2.4%, with 18.5% of that increase due to fuel prices. Service costs rose 0.4% and YoY prices have risen 11.6%, but the core index has eased slightly to 8.3%.
• U.S. Industrial Production – declined (0.2%) from a month earlier in June and missed forecasts of a 0.1% increase. Manufacturing output fell (0.5%) for the second consecutive month with durable and nondurable manufacturing falling (0.3%) and 0.8%, respectively. The mining index moved up 1.7%, while the utilities index decreased (1.4%).
• U.S. Retail Sales – expanded 1% MoM in June which beat expectations of a 0.8% rise and up significantly from a (0.1%) decline in May. Retail sales are not adjusted for inflation, as sales at gas stations bumped up 3.6% and non-store retailers expanded 2.2%. Lower sales were found in building materials, clothing, and general merchandise stores at (0.9%), (0.4%), and (0.2%).
• U.K. Industrial Production – rose by 0.9% in the month May after a (0.1%) decline the month previous. This is the strongest activity since January and output also increased for electricity and gas at 0.3%, but dropped for mining and water supply, at (2.7%) and (0.2%), respectively.