Is this what an economy in crisis looks like?
Markets are indeed forward looking but at this stage, it is starting to feel like even markets might be getting ahead of themselves! The consensus tends to be that the current rate hiking cycle will tip the economy into a recession and this probably will be the case. What degree of a recession is up for debate. What is most interesting about this market, however, is that it has likely priced in a recession (or worse) before it has even happened! This begs the question of what do markets do once it actually comes? If markets are discounting a recession, they could go up as we actually enter it. With markets always seeming to love keeping investors scratching their heads, we would not be at all surprised with this scenario playing out. Regardless of whether a recession actually comes, small and mid-cap stocks are being priced as if we are in the middle of a crisis and we think it is fair to ask whether it is actually that bad out there?
Don’t get us wrong, things are not particularly great and there are not many things to grab hold of to make oneself overly optimistic but it almost seems this lack of positive catalysts is more the problem than anything. Without a positive catalyst, even a mild economic slowdown leaves investors without many great reasons to buy stocks. While this void of optimism can wear an investor down, it is important to remember that where things stand now, we are not in some sort of economic crisis. Meanwhile, looking at SMID-caps trading at or below covid trough multiples and flirting with 2008 valuation levels, we would forgive you for thinking otherwise.
Zooming out a bit, we think there are a few key points to make around the economy:
Employment and wages are strong: This might not be ‘great’ for the issue of inflation but it is good for almost everything else. Further, it is probably hard for a deep or painful recession to take hold as long as these two areas remain resilient. Of course, some may argue that this is a case of good news being bad news where strong employment means inflation is not going away. Nonetheless, this is not what you typically see in or immediately prior to some sort of economic turmoil.
Profit margins remain high: In fairness, margins are coming down but they are coming down from all time record highs to ‘just’ elevated levels compared to prior decades.
Economic data looks ‘ok’: The economy, whether you look at GDP, PMIs, earnings results, consumer confidence, etc. looks ok. We know, ‘ok’ is not particularly scientific but probably perfectly explains the situation of an economy that is ever-so-slightly growing. While not ‘great’, it is also not a crisis or disaster. It also shows an economy that is normalizing and slowing down which, depending on one’s view, is a healthy outcome. Ironically, at this stage, an economy that continues to decline is probably a positive for the markets, as it means inflation is more likely to come under control. PMI probably goes lower from here, but again, this is what markets want, especially if it is orderly.
Rates are higher and the economy is still standing: Pose the last year’s interest rate scenario to anyone before this cycle began and most people probably would have predicted the economy could not handle it. Well, here we are and the main complaint seems to be that the economy remains too strong regardless of rate increases! The overall point here though is that rates aren’t particularly high compared to history and nor does it seem like they will or need to go high compared to history. So, interest rates are another scenario of not helpful but again not at crisis levels. We have a chart displaying historical rates further down, so we won’t be redundant and put that chart here.
Inflation is higher than everyone would like but coming down so far: The jury is still out to some degree but inflation seems to be trending in the right direction and the further through 2022 we get, the more likely inflation will fall. The inflation and interest rate risk is a bit of a strange one simply because the two are reflexive in nature. If inflation goes higher, so too do interest rates and vice versa (or at least interest rates stop increasing). So, if one of these is solved, both are more than likely solved. Inflation and its future path are really the main risk here and while it is not being overly cooperative, our range of outcomes seems far more certain than six months ago, it appears to be trending in the right direction, and even if it is higher than most would like, should normalize around levels lower than where it is today.
Again, while there are things to worry about, this set of economic drivers and risks hardly looks like something that should rival valuations seen during a complete economic shutdown in covid or the existential crisis of the financial system collapsing in 2008.
We can hear the rebuttal of ‘but what about when the FED hikes the economy into a recession!’. That is the point. All of these things could turn for the worse. A recession can come, employment can fall, earnings might decline, but the whole issue here is that markets are already expecting and pricing in this occurrence. Meanwhile, if these risks do materialize, it arguably neutralizes markets biggest concern which is higher interest rates and inflation. So, at some point it almost becomes a bad news is good news scenario. The bigger question is to what degree a recession is being priced in but to us, looking at where SMID-caps are relative to their history, it certainly looks like we are already pricing in a crisis type of scenario. Even if we go more of the doomsayer route with the popular quip that all of these changes mean ‘something is going to break’, SMID-Caps again already appear to be pricing in that whatever ‘it’ is, has already broken!
One of the scenarios or fears we often hear is that if rates go up, then valuations need to trade down to some P/E that is sub-15X. This may be the case some day, but markets have existed in times of higher interest rates and traded at higher valuation multiples in the past. So, while this thesis can be a frightening one, we don’t think it really holds much weight. From 1991 to 2002, 10-year treasury yields traded in the 5% to 8% range while the SPX PE traded consistently above 15X. From 2005 to 2022, the P/E ratio never sustainably traded below 15X. Meanwhile, yields traded in a range of 4.8% to 0.1% and currently sit at right around 4%. In the late 80’s and early 90’s, we had periods where 10 and 2-year yields traded in the 7% and 8% range and P/Es were in the 15X to 20X range. Again, while the prospect of a ‘new-normal’ and valuations having to trade down to a ‘10X PE’ garners a lot of attention, we are not so sure there is much solid footing for such a thesis to stand on.
We think the biggest problem with markets is more related to the fact that there is not a whole lot to be particularly excited about in the current macro environment. Layer on a market that for lack of a better term has been bleeding on an almost weekly basis for nearly nine months now and you get a recipe for investor despondency. As we think we have highlighted above, the macro situation might not be very endearing at this stage but things also do not look that bad and they are almost certainly not as bad as covid or 2008, which are the levels SMID-caps are being priced at currently.
