Where’s the recession?

Bull market unfolding, just not the one most investors expect

Last time, I looked at some of the factors that are likely to give rise to a new bull market. But the question still lingers: Where’s the recession we’ve been hearing so much about?

A key reason why the recession call has been the wrong one is an under-appreciation for persistent government deficits and spending. Most investors are still assuming a fast-moving downturn like 2008 or 2020. But the current environment is far more like the 1950s and 1960s, where labour shortages and an investment boom prolonged the cycle and took longer to unfold. And, investors should not forget that the 2010s were a “clean the house” decade, with deleveraging being the most durable trend. Now debt levels and, thus, interest-rate sensitivity, are far lower, primarily in America and the Eurozone.

U.S. housing trends, which have been persistently surprising to the upside, prove the larger point. Why has this resilience caught most investors by surprise? Simply because most investors put too much emphasis on higher mortgage rates and not enough on strong household balance sheets, demographic trends (millennials moving out of their parents’ basements) and, most importantly, a decade of underbuilding (from GFC PTSD).

Recession already discounted

The final point about a new bull market relates to sentiment and investor positioning. Even if a recession does arrive, what has already been discounted in markets? Would anyone be caught off guard and change their investment posture if a downturn did unfold? In an environment of chronic recession calls (now with us for over 18 months), investors remain deeply pessimistic. Most have already aggressively de-risked. From Bank of America’s widely tracked fund manager survey, the pros have the highest overweight to bonds since March 2009. Relative to history, the top three investment overweights are bonds, consumer staples, and cash.

Investors are vulnerable here. The big turning points in yields in the past show that history’s greatest secular bear markets in bonds (“real rate reversals”) all started with major mortality crises, such as pandemics, famines, and military conflicts – exactly the climate we have today. What’s more, cash rarely outperforms in this environment. According to data from JP Morgan, during the last seven business cycles, in the two years following the last rate hike from the Fed, cash underperforms duration assets by an average of 14%.

In an October 2022 Ask Forstrong article entitled “Pivotal Moments: Are Markets Forming A Bottom?”, our portfolio management team concluded that the conditions for a durable market bottoming had arrived. From the piece:

“Why should we be discussing a new bull market when the outlook seems so bleak? The best answer is that levels of investor sentiment are now consistent with past bottoming processes. Markets do not form tops when investor sentiment is universally pessimistic. Rather tops occur with everyone predicting ever-sunnier skies ahead…markets fully discount that view and upside surprises become much more difficult to deliver. By contrast, bull markets are born out of pessimism.”

The above view remains in place: Markets continue to move through a bottoming process and are finding a new equilibrium with new leadership. This is always bumpy. And it always takes the shape of the classic “wall of worry.” A heated rally is likely to continue simply because so many investors are not yet in on the gains.

Looking ahead, we are now again at a moment in time where “upside surprises” can start to deliver again. Which ones? Chinese growth, just when everyone has given up on the world’s second-largest economy, is almost certain to deliver a positive surprise in the second half. While an imminent end to the Ukraine war may not be here, investors have underestimated European resilience (witness the impressive speed with which Berlin found substitute sources of gas and built emergency infrastructure). Ongoing European dynamism would still surprise nearly everyone.

Lastly, trends in corporate earnings will surprise markets and draw investors back into equities. Many have pointed out the average S&P 500 earnings recession bottoms out with a 16% contraction (currently at -6%). But this assumes a disinflationary backdrop like the one we saw in 2008, where nominal growth and profits dropped sharply. Amid higher inflation, investors need to think differently. Nominal growth is far more important than real growth for earnings. Looking at it that way, S&P 500 revenues have been robust and are still increasing, even as margins are coming down. This is the same phenomenon as happened during the 1970s where rising nominal sales never led to a big earnings collapse.

Investment implications

Many investors are still using the 2010’s playbook, expecting a return to an era of slow growth and subdued inflation. This is a classic case of investors becoming accustomed to the conditions of the past and extrapolating them well into the future.

Yet the world has already moved on from that macro regime. Over time, asset classes that do well will reflect the underlying macroeconomic dynamics. Higher yields will now weigh on non-productive assets like cryptocurrencies and longer-duration assets like growth stocks. Under that view, the rally in the Nasdaq in 2023 should be viewed as a classic “echo bubble,” a pattern that can be seen in periods after all the biggest manias. Many investors refuse to abandon the assets that have made them a lot of money in the past. And so they continue to pile in.

But winners of the past bull market are rarely winners of the next one. Instead, investors need to stay oriented toward an environment of “higher for longer” interest rates and resilient growth amid higher fiscal spending. In the same way that the consensus consistently overestimated growth and inflation in the 2010s, the opposite will now occur: Investors will, as they have so far this decade, consistently underestimate growth and inflation. Positive economic surprises will lead to flows into equities (from cash and bonds) and rotation within equities (from defensive and tech sectors to cyclical and international stock markets).

A new bull market is indeed unfolding. Just not the one most investors expect.

Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. This article first appeared in Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

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