Is the bond market, in expecting a Fed policy pivot, overplaying the risks of a recession?
The first quarter of 2023 saw positive performance across financial markets. Every major asset class, with the exception of commodities and the USD, has risen year to date (YTD) and handily beaten cash. The US technology sector-focussed Nasdaq index outperformed other major markets, with 17% YTD gains, as expectations for the peak Fed policy rate tumbled from almost 6% to just 5%. Money markets are now anticipating the Fed to deliver its final rate hike in May 2023 and then cut rates by almost 70bps by the end of the year. Meanwhile, the 10-year US government bond yield has declined by 60bps to 3.4%.
Is the bond market, in expecting a Fed policy pivot, overplaying the risks of a recession? Or, is the stock market right in expecting that such a policy pivot will lead to better equities performance? While I often hear that we are headed into the most anticipated recessions of all times, the debate is far from settled. Hence, a review of history and investor positioning is likely to shed more light on both sides of the argument.
1. A Fed pivot does not necessarily imply better equity market performance
Historically, an end to a Fed hiking cycle and a subsequent easing of monetary policy is bullish for equities on average, but the variance of outcome is large, with equities delivering strong returns in some years and substantial losses in others. Regardless of policy pivots or rate cuts, equity markets generally continue to decline further during periods of recession. For example, during the 2000-2001 and 2007-2008 cycles, equities fell over 40%, despite aggressive rate cutting and quantitative easing by the Fed. Equity markets took more than two years to bottom after the final rate hike.
In contrast, episodes that saw equities climbing further after the final hike tended to be non-recessionary, with more resilient economic growth and earnings being a key differentiator. The best equity market performance, however, tends to occur during the tail end of the policy easing cycle and just before the first Fed hike. This is usually a time when inflation is mild, unemployment is falling, and the outlook for growth and earnings is starting to improve.
2. A trough in growth is more important for equities than a Fed policy pivot
While Fed rate cuts can boost liquidity and equity market valuation, that on its own is insufficient for equities to perform, especially if it is outweighed by deteriorating economic and earnings growth. In fact, over the past few decades, a bottom in equities had typically coincided with a trough in the US Conference Board Leading indicator. We also know that equity market performance corroborates strongly with earnings growth.
Major leading indicators, such as the global manufacturing PMI and the spread between long-term and short-term interest rates, have been signalling a recession since last year. We are also seeing signs of initial cracks to the US labour markets as both payrolls for temporary and initial jobless claims, two early warning labour market indicators, have declined on a year-on-year basis. Money supply has also started to contract for the first time on record. This suggests we are yet to see a bottom in economic conditions. Thus, there are considerable risks of a renewed decline in equity markets.
3. Investors already positioned for a recessionary outcome
While economic growth data is deteriorating and our recession probabilities have increased since the beginning of the year, investor sentiment and positioning are pretty bearish. The latest Bank of America Global fund manager survey continued to signal investor pessimism, with sentiment and positionings levels among the lowest in the past 20 years. Taking the survey one step further, we tabulated the returns on various risk assets following the lows in the sentiment and positioning. The results suggest maximum investor pessimism is a contrarian signal for risk asset returns.
While not a base case, if the ensuing economic growth deterioration is too modest or if data continues to positively surprise against depressed expectations, this could be one factor fuelling a further rise in equity markets as wrong-footed investors chase the rally.
Table: Returns on various risk assets before and after each trough in percentile rank of growth expectations, cash and equity allocation in BOAML Fund manager survey
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