With inflation at multi-decade highs and inflation expectations inching up, the Fed has reprioritized its focus from supporting growth to quickly taming inflation. The Fed has stated (unequivocally, to our ears) that they would gladly risk a recession now via restrictive policy to avoid the bigger risk of higher and more entrenched inflation later. This is the right long-term policy, but means that economic growth will slow in the near term. Interest rates across the curve are materially higher year-to-date. Frontend rates will continue higher in-line with Fed guidance, but we expect long-end rates to stabilize as growth slows and the Fed’s inflation fighting credibility grows.
Whether or not we see an actual recession in the next year will be determined by the interaction between the economy’s positive momentum, the persistence of inflationary pressure, and the restrictive effects of Fed monetary policy. On balance, we expect growth to slow to a 0-1% annualized rate. However, should a recession come to pass, we presently expect it to be more mild than severe, owning to the underlying strength in the labor markets. More importantly, recession or not, we think that corporate earnings estimates need to come down from overly optimistic levels. Growth will slow and the combination of cost pressures and worried consumers will likely pressure margins. Overall, we think forward earnings estimates look about 5-10% too high.
Reassuringly, from an investor perspective, a fair amount of pessimism has already been priced into the market. Various measures of investor sentiment are quite weak, which generally signals good entry points for long-term investors. Similarly, consumer sentiment is near all-time lows; prior troughs in this gauge dating back to the early 1970’s have rewarded brave investors with average returns of 25% over the following 12 months1 . Reviewing the history of 17 prior bear markets in US stocks dating back to 1900 provides a dose of humility, given the wide disparity of severity and length of prior drawdowns. If nothing more, this exercise reminds us that patience is a requisite ingredient for good long-term returns: median prior drawdowns have gone lower and taken longer to bottom than the current episode.
Risk assets valuations look fair, but not cheap. Many pundits point out that market drawdowns of 20% or more have historically been great entry points. This is true, but valuation matters more than price. 2021 valuations were rich, so the move lower in risk assets thus far has merely brought valuations back down to earth from unsustainably lofty levels. In fact, for stocks, the year-to-date move is almost entirely explainable by the move in risk free rates, rather than a true increase in extra compensation investors get for taking on the risk of owning stocks. As for private equity, we think assets will be remarked lower as net-asset values get market-to-market over the coming quarters, potentially offering attractive entry points for investors underexposed to this asset class.
Overall, if we survey all of these elements to our analysis – inflation, interest rates, economic growth, corporate earnings, sentiment, historical context, and risk asset valuations – we shake out as being cautious over the short-term, but more bullish over the long-term. Higher interest rates and a mild recession could be just what the doctor ordered to ween our economy off the morphine drip of growth-supportive Fed policies, but we would prefer to get a better sense of how severe the withdrawal symptoms will be before getting definitively more aggressive.
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1 JP Morgan, Bloomberg, and PCIA Analysis
The preceding commentaries are (1) the opinions of Scott Duba and Brett Newell and not necessarily the opinions of PCIA, (2) are for informational purposes only, and (3) should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.
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