- While many cyclical stocks are already priced for a mild or deeper recession, we think the probability of a recession in 2019 is much lower than the markets are pricing in.
- Unemployment is at historically low levels, wages are accelerating and consumers have used these tailwinds to fix their own balance sheets.
- We think a normalizing term premium will push interest rates higher and further fuel the three-year old bond bear market.
It may seem like heresy to say it these days, but, as a human creation that ultimately reflects shifts in fear and greed, the market sometimes over- and underreacts to changes in underlying fundamentals and valuation. At a macro level, we will give an example for each type of reaction where we think the market may be getting it wrong.
Starting with overreaction, investors are intensely focused on what they rightly perceive as a critical driver of markets: the probability of a U.S. recession in 2019. As fear crept into the market in 2018 it did not do it quietly. Valuation multiples compressed by over 20% as growth expectations for 2019 were almost cut in half. By many metrics the financial markets seem to be pricing in a 50% or higher probability of recession over the next 12 months, with many cyclical stocks already priced for a mild or deeper recession. Most recession models have also raised the probability of recession in 2019, but they remain at approximately 20% or less.
Currently, we would bet with the models. Why? The U.S. consumer, or what we might call Main Street as opposed to Wall Street, is roughly 70% of the U.S. economy, and is broadly in great health. Unemployment is at historically low levels, wages are accelerating, and consumers have used these tailwinds to fix their own balance sheets (Exhibit 1). The models are likely doing a better job of reflecting the importance and health of Main Street, while the market continues to climb a steep wall of worry as the scars of the Great Financial Crisis (GFC) run deep. After all, the GFC was a solvency crisis that almost collapsed the economy into depression, and the market remains deeply suspicious of all things cyclical.
Exhibit 1: Consumer Balance Sheets Have Improved
Just measuring the risk of a U.S. recession may miss critical macro risks. After all, we had a deep energy recession in 2016 that did not tip us into a broad recession, but certainly elevated market risk. As liquidity has become scarcer, more risks are emerging globally that could be far larger in magnitude than the 2016 experience. However, we think any major issues will turn the monetary spigots back on, and risk premiums should recede from currently elevated levels. However, as Wall Street begs for an infusion of liquidity, we think the market is underreacting to an ongoing change in broader policy.
This market cycle has been dominated by monetary policy, which had an explicit goal of supporting asset prices to drive a wealth effect. Essentially, the liquidity pump was blown wide open to directly benefit Wall Street, in order to indirectly help Main Street. The unexpected problem with this policy is that it inflated asset prices, which greatly exacerbated wealth disparity. The resulting voter anger has driven the rise of populism and has shifted the focus to directly benefiting Main Street through fiscal policy. With the U.S. on track to experience record deficits outside of a recession or a major war, populism, by encouraging fiscal expansion, is forcing a tightening of monetary policy. This modest liquidity shift has already caused market tremors and slower growth, and we expect both policies to now work in concert. If they do, we think a normalizing term premium will push interest rates higher and further fuel the three-year old bond bear market. Despite the recent drop in yields, we believe the probability of a continued bond bear market has gone up. Wall Street will attempt to restore the old price momentum game despite recent large cracks and signs that new winners are starting to emerge. We have tried to position the portfolio to benefit as the market adjusts to the new realities of a shift in focus to Main Street, and despite recent extreme market turmoil we are seeing early but encouraging signs.