Jonathan Marriott, Chief Investment Officer
Since the start of the year, we have experienced rising inflation and higher interest rates, which have both weighed on markets. Bond and equity markets have sold off and investment portfolios have felt the impact as a result. We tend to prefer third party managers, who favour growth stocks with quality earnings over more cyclical and unpredictable earnings; as such, they generally have little exposure to the energy sector which has risen steeply recently, resulting in them underperforming their respective index. This approach saw us through the pandemic crisis with a smaller drawdown than others and a positive return overall.
Concerns of a recession
We were reluctant to chase the stocks that suffered during the pandemic and have outperformed during the recovery given their less dependable income streams. The energy sector in particular is driven by oil and gas prices, and we should be cognisant of the years of underperformance from this sector previously.
At present, fears in the market are for a recession brought on by inflation and central bank monetary tightening. Recessions are not usually good for commodity prices as durable goods orders from households and businesses tend to fall swiftly. When markets are distressed, it is important to look through the noise and short-term news stories and instead focus on the long-term earnings stream.
Let us start by looking at the S&P 500. The 17.5% fall this year leaves us with a prospective price to earnings (P/E) ratio of 17. That is an earning yield of 5.8%, which looks cheap relative to 10-year US Treasuries at 2.85%. Other developed markets around the world have a lower P/E ratio, higher earnings yields and lower government bond yields. However, there are two sides to this relationship: firstly, the level of earnings and, secondly, the prospective interest rates. If there is a recession, then earnings may fall while interest rate rises may be curtailed.
The differing impact of recessions
A recession is not our central view, however, when analysing the current situation we look back to see how negative it would be if such an event were to occur. While history will not repeat itself exactly, I have looked back over the last fifty years to compare the impact of recessions on earnings.
I identified six recessions during this time and, in each case, the earnings on the S&P 500 index declined. However, the size of the decline varied considerably from 11%[1] in the 1980 recession to 52% in 2008/9 financial crisis. Two recessions (1973/74 and 1991) were associated with sharp rises in oil prices, when earnings decreased by 21% and 42% respectively. The 1991 recession came as the Federal Reserve (Fed) raised rates by 3.25% from 6.5% to 9.75%, which coincided with an oil price rise of nearly 150% (WTI futures) so may be the best comparison with today. In 1991, the S&P 500 index fell 19% during the recession but recovered and reached a new high before the recession ended. It should also be noted that the earnings declines were short-lived and usually recovered rapidly after the event.
If we take the 1991 example and revise down the earnings by 42%, then the earning yield is still 3.3% in excess of a 2.9% treasury yield. If we price in a 21% cut to earnings, the yield falls to 4.6%. If we were to enter a recession, it is hard to imagine the Fed keeping to its present course of interest rate rises or, if they do, the bond market would probably begin to price in rate cuts. This, combined with a recovery in earnings, means that equity remains the most attractive place to be in the long run. In any event, if the central banks see this as a risk they may look to head it off making a more attractive scenario for investors.
The risk to these scenarios is that inflation becomes more entrenched and the Fed has to raise interest rates further and engender a more severe recession in order to control inflation. Increased food and energy price rises are impacting the consumers ability to spend on other things. This week, we saw that the latest US Consumer Price Index had declined from 8.5% to 8.3% and is expected to fall further in the months to come, as the steep rise in commodity prices last year work their way out of the annual numbers. Rising costs will continue to feed through, but we expect inflation to move back towards the Fed’s 2% target as we move through next year.
Labour market easing
Post-pandemic, we have seen a tight labour market with more vacancies than people looking for employment. However, there are early signs that the labour market is easing. People who thought they could retire on healthy pension pots may be having second thoughts, as their investment portfolios decline and inflation starts to bite. Meanwhile, those who thought they could live off trading cryptocurrencies may be getting a dose of reality with sharp falls in cryptocurrencies and related instruments.
In this article, I have focused on the US equity market; other markets are on lower multiples and have lower interest rates so may be at least as attractive. We focus on companies that can compound earnings over time so we may miss out on some moves in more speculative positions. These stocks do not outperform all the time, however strong earnings compounding over time in the long run produce the best returns. This year, so far, has been one of those periods where several such companies have underperformed the wider index. The earnings yield I have modelled assumes no recovery and still looks attractive. We tend to favour companies that can continue to grow earnings and managers that pick such companies. We also may well have passed peak inflation in the US and peak Fed hawkishness, which will support a recovery in equity markets.
We cannot predict markets from one day to the next and we are seeing sharp intraday movements. We encourage people to stick with the market. Partially invested clients looking to average in should continue to do so. Remember the old saying that it is time in the markets not timing the markets that make the best returns in the long run.
[1] 12-month trailing earnings: Bloomberg
