Over the last week, equity markets have snapped back from oversold territory, which brought a sense of relief to investors. It is unsurprising in bear markets to see relief rallies, which can be unpredictable in magnitude and duration. However, we continue to see a fragile environment for risk assets over the next 12 months and advocate for a defensive stance.
As we enter the second half of 2022, the market will weigh the odds of an impending recession and its impact on earnings and valuations. As Federal Reserve (Fed) chairman Jerome Powell stated in his testimony to the Senate Banking Committee last week, a recession “is certainly a possibility” and “whether we’re able to accomplish a [soft landing] is going to depend to some extent on factors that we don’t control.”
Our macroeconomics team now sees 50-50 odds of a recession in 2023. We see early signs that higher rates and tighter financial conditions are beginning to form a drag on the economy. Real yields, as measured by the 2-year US Treasury yield minus the 5-year/5-year forward inflation breakeven rate, have surged into positive territory due to expectations of rate hikes, and currently have exceeded the peak level in late 2018 when the Fed ended its last hiking cycle as conditions turned overly restrictive.
Exhibit 1: Real yields have risen above 2018 peak levels when conditions turned overly restrictive
Source: Bloomberg, Bank of Singapore
Note: 2-year US real yield shown is calculated as the 2-year US Treasury yield minus the 5-year, 5-year forward inflation breakeven rate
Inflection points in the US unemployment rate have been a reliable indicator of recessions since the 1970s. When demand falls as economic growth declines, companies reduce hiring and unemployment rises. Our macroeconomics team points out that the Sahm Rule has an excellent track record of signalling recessions, marking the start of a recession when the three-month moving average of the US unemployment rate rises by 0.50 percentage point or more relative to its low during the previous 12 months.
In the event of a recession scenario, we are cautious that the deterioration of corporate earnings could lead to further valuation downside for global equities and credit.
An analysis of US equity bear markets after WW2 shows that the average peak-to-trough decline is 33%, lasts about 13 months, and takes about 24 months to recover to its last peak.
Notably, this includes two outliers – the 2000 tech bubble crash and the 2007 Global Financial Crisis with peak-to-trough declines of 49% and 57%, respectively. The declines during those two crises were significantly greater given severe asset bubbles and the structural impact on banking and consumer balance sheets.
Today, a potential recession scenario would be driven by Fed concern over inflation. With relatively healthy balance sheets in the banking sector and limited candidates for a sizeable asset bubble crash, we think this bear market is less likely to show declines as deep as those in the 2000 and 2007 crises. Excluding these two outliers, the average bear market decline is 29% and lasts for 11 months.
Additionally, historical analysis of bear markets also shows that the market low on average takes place about six to nine months before corporate earnings start to rise again.
These analyses suggests that while we may not have reached a definitive bottom in equities, if a recession scenario takes place, at current levels we have likely already worked through a significant part of the peak-to-trough downside. Also, in a 2023 recession scenario, considering that a typical recession lasts for three to four quarters, we could see equities put in a bottom in 2H 2022 or 1H 2023.
Exhibit 2: The inflection in US unemployment rate has historically signalled recession
Source: Bloomberg, Bank of Singapore
Note: Shaded areas indicate US recessions
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