Roger [00:00:00] Historically, US equity markets have often put in a major low around the month of October. The Dow Industrials has apparently had its best month in 50 years. And U.S. GDP has had a decent rebound from the soft patch of the first two quarters of 2022. Does that mean that the equity lows are in, or has 2022 just been the precursor to a proper recession and new equity lows that might materialise in 2023?
Roger [00:00:26] That's The Big Conversation.
Roger [00:00:32] In early October this year, we looked at some of the call buying strategies that institutions were implementing in order to hedge their equity underweight. Bearish sentiment was very, very strong amongst professional investors, hitting record levels. Whilst implied volatility for S&P options was fairly valued, making call options look attractive.
Roger [00:00:50] But outside of the Dow industrials, the rally has been relatively anaemic. The Nasdaq 100 has been held back by some of the Mega-Cap tech names gapping lower last month. Whilst the basic target for the S&P 500 was a 200 day moving average, around 4100 on Wednesday, when we filmed this before the FOMC announcement.
Roger [00:01:08] The point here is that the contrarian case for a rally was starting to build a few weeks ago. However, what really matters is whether the contrarian case for a rally, could become a full blown bull case for the equity market. And for the US, this will probably depend on the outcome for employment, for which the housing and construction sectors could be key.
Roger [00:01:30] So far, the employment outlook has remained relatively tight. Now this data is notoriously backward looking and will probably be revised higher in future. But for now, the jobs market is not decisively weakened.
Roger [00:01:43] And in the past we have argued that the jobs market might be tight, but it's not particularly strong. And this is because real wages were generally rising at a slower pace than prices, and that's contributed to the cost of living crisis. Indeed, many small businesses and the median household have probably been in a recession for some time.
Roger [00:02:02] But the overall US economy has not. Yes, it has had two consecutive quarters of negative real GDP growth, but the two quarters definition of a recession is a European definition. The US National Bureau of Economic Research definition is less clear cut. They're looking for signs that a period of slowing growth has depth, duration, and dispersion - with dispersion, meaning that the slowdown reaches most parts of the economy.
Roger [00:02:28] And so far, the slowdown has been relatively narrow. Many large corporations have not yet been affected and employment has remained sticky.
Roger [00:02:36] But why does the employment outlook matter for equities?
Roger [00:02:39] Well it's because there's a relatively clear relationship between unemployment and recessions. Unemployment surges through a recession. Now, this is largely coincident, but the majority of the rise in unemployment has historically taken place through the main part of the recession.
Roger [00:02:54] And rather than a full recession, the slowdown we've had so far in 2022 is really a price shock and a financial market adjustment to inflation and interest rate expectations. This is not the slowdown that you've been looking for. For the bears, the true recession, if it's going to happen, should still be ahead of us.
Roger [00:03:11] But also, why should the bears care about a recession? Well, that's because US equities have made a major low either during or after the main part of each recession since 1950. On every occasion. And even when the equity sell off has been relatively muted, like 1980 and 1991, the equity market low was still during the recession.
Roger [00:03:33] Therefore, if the equity market lows are taking place at this moment in time, either we're already in a proper recession and therefore future GDP and unemployment revisions will have to be fairly sizeable in order to backdate a true recession to this current period.
Roger [00:03:49] Or if and when the true recession occurs, we will get price action from the equity market, that will need to be markedly different to the price action experienced during every single recession since the 1950s.
Roger [00:04:03] If the recent lows are indeed the major lows, then equities will need to rally through the next recession. Or we need a sizeable rally from here, so that if we do get the typical equity price action during the next recession, the market makes a higher low than today's lows. And we do have an example of that. The 1980 lows were not breached by the 1982 lows, though it was fairly close.
Roger [00:04:31] But also, why should rising unemployment lead to weaker equities? Well, that's because rising unemployment leads to redemptions and liquidations. Loss of income or fear of future loss of earnings means that households sell down assets to generate cash. And this is often indiscriminate and accompanies the rise in unemployment. And that's why we often get that disorderly low in equities during a recession as unemployment picks up.
Roger [00:04:55] So far, the combined losses in the equity and bond market have been absolutely huge, but the impact has not yet been realised. And that's because many of these losses will have implications for future returns, but may not yet be as apparent for households today. Household equity flows have only just turned negative; having registered inflows during the first half of 2022.
Roger [00:05:17] Households have not yet really turned bearish. The bears from the ranks of the professional community or the retail traders. And here we should make a distinction between retail trading; which is increasingly utilised huge volumes of very short dated options. And general households who passively accumulate assets, and have automatic allocations by things like 401ks. These flows usually take a hit when unemployment significantly increases. And as we've seen, this has not yet occurred.
Roger [00:05:46] Of course, there is also the possibility that we don't get a true recession at all, but that would require the employment data to remain extremely strong. But there are now a number of headwinds on that front that are beginning to emerge.
Roger [00:05:59] The huge year-on-year increase in mortgage rates, which in percentage terms is the fastest on record, (admittedly starting off a very low base), but that's beginning to bite into the housing market. Home buyer sentiment has understandably taken a hit.
Roger [00:06:13] The NAHB housing index has dropped as quickly as it did into the GFC and COVID crises. And although mortgage prices have been significantly higher in the past, it's the rate of change that matters. Mortgages that have moved to 7% from 2% are far, far worse, than mortgage rates at 7%, but have come from 15%.
Roger [00:06:35] And the real issue here is less about house prices per say and more about the slowing down of activity in a sector that employs a significant number of people. A drying up demand will lead to a reduction in headcount within the industry,.
Roger [00:06:50] And the trucking industry is also starting to see a reduction in headcount as volumes fall and the industry readjusts back down from the excesses of goods demand during the COVID era. Additionally, many tech firms are cutting back and Start-Ups, who were able to find excessive headcount when rates were close to zero, are now having to balance the books by shedding labour.
Roger [00:07:09] And wage discussions are also on the rise. Many payment negotiations are seeing inflation beating, demands materialise, and these will start to erode corporate margins that many companies have maintained by passing on higher prices to customers whilst keeping real wage increases in negative territory. If margins are under threat, corporates tend to reduce headcount.
Roger [00:07:30] And therefore pay is fairly certain that unemployment is going to rise, and that would suggest recession, which in turn implies that we should expect future weakness in the equity market.
Roger [00:07:41] But can we get a bounce first? And if we did, can it go far enough so that if a real recession emerges, the lows are already in place?
Roger [00:07:51] Now, this may sound pretty obvious, but this will depend on sequencing. How quickly will unemployment meaningfully pick up? How quickly will a Fed pause or pivot? And we've recorded this before the FOMC. So the views here are about the longer term relationship between the economy and inflation.
Roger [00:08:07] Can the liquidity outlook turn up before unemployment begins to bite? And if it does, will that have dangerous implications for a rebound in prices? Policymakers are currently looking at ways to improve the liquidity of the Treasury market. Improvements in the bond market should help support other risk assets, but what supports the equity market could also support inflation.
Roger [00:08:28] And currently the market has decided that a pivot could be as simple as a slowdown in the trajectory of rate hikes. Now, whilst a declining rate of change in rates is welcome, rate hikes are clearly not a pivot. The rate of change has to slow at some point, but neither is a pause, a pivot.
Roger [00:08:47] Historically, the Fed has generally pushed interest rates in excess of core inflation before they've started to cut. That requires the inflation data to drop back rapidly from current levels, or they're going to have to tighten more than the market currently expects. And this is where the Dirty Dancing really takes place.
Roger [00:09:03] If the Fed softens their stance too early, then a rebound in expectations could prevent prices from dropping quickly enough to allow the Fed to truly pivot. The risk is that an early pivot would push up longer term inflation expectations and longer term yields, creating the potential for more pain in assets the price of the long end of the curve.
Roger [00:09:23] Therefore, the Fed probably needs to see more weakness in the real economy before they feel they can cut rates. That requires unemployment to go higher, and ISM manufacturing to drop decisively below 50. ISM New Orders, minus ISM Inventories suggest that a bigger slowdown is coming. And the conference board CEO confidence index has dropped to recessionary levels. But so far companies have continued to hoard employees, and that makes the Fed's job a lot harder. Turning into a tight labour market could lead to a recurring pattern of price peaks, that were seen in the 1940s and then again in the 1970s. So credibility is key.
Roger [00:10:01] And as we've mentioned before, if the market keeps pricing in the pause or the pivot, then the Fed has less need to reverse course and may even be emboldened to go harder. The longer term bull case probably requires a very rapid deterioration in the real economy. The short term bull case is largely sentiment driven, and that contrarian argument is pretty strong at the moment.
Roger [00:10:23] Remember, the active managers who are bearish are no longer in control of the majority of assets. That baton was handed to the passive community, which includes rules-based funds like risk parity, and they don't do sentiment surveys.
Roger [00:10:39] The active managers have already hedged themselves. And that has been one of the major reasons why this equity market and its declines have been pretty orderly so far. But we've not yet seen household capitulation.
Roger [00:10:51] Meanwhile, others have pointed to the relatively subdued VIX as an indication of a bullish setup in equities. However, we should be very wary of that. In 2008, the VIX dipped below 20 a few weeks before the market collapsed and volatility exploded higher. Spot VIX is a very poor predictor of future returns. For 2022, it has been better to buy the market when the VIX has been high rather than low, because that has usually been coincident with the dips.
Roger [00:11:20] Equity volatility is also subdued relative to bond, represented by the MOVE index, and FX volatility. But volatility usually spreads from bonds and FX towards equities. That hasn't really happened yet because the decline in equities has been relatively orderly. The VIX around 25 reflects the actual volatility of the S&P 500. Call options are around fair value when compared to the price moves in the underlying market.
Roger [00:11:43] And that's why institutions have still been intent on hedging an underweight equity position and may now be looking at the big December expiry on the 16th of that month, two days after the final FOMC meeting of 2022. Prior to the FOMC meeting this week, the 4200 calls were offered at an implied volatility of 22.5. Though a rally to that level of 4200 requires the S&P to break the 2022 downtrend.
Roger [00:12:10] Also, the pullback in the dollar has also helped generates a rebound in equity markets. But regardless of what the Fed does, the outlook for the ECB and BoJ, is one which should continue to dilute their own currencies; by yield curve control in Japan, and printing cash for the energy crisis in Europe. A longer term pullback in the dollar, requires the Fed to hit the brakes because the economy is coming off the rails. If they hit the brakes before the economy has come off the tracks, then they risk boosting inflation once again. It's such a tightrope that they're walking.
Roger [00:12:40] In many ways, the best outcome would be for the real economy to deteriorate fast enough for the Fed to properly reverse course before risk assets have a chance to react too negatively. But that sequencing would also require a significant slice of luck.
Roger [00:12:54] In reality, we should probably expect the real economy to deteriorate more slowly into 2023, before unemployment picks up as that recession rolls in. And historically, a decline in equity markets would accompany that. But the key question is... From what starting level?
