Recently, the S&P500 briefly touched bear market territory, having plunged more than 20% from its previous peak before reversing course later in the session. As main Western equity market indices saw another week of sustained declines, some market pundits see themselves vindicated in their earlier prediction of a bear market.
On the real economy side, recession fears have reached frenetic levels as financial conditions tightened further. Is the case for a soft landing finally off the table?
At least markets do not think so right now. In fact, the S&P500 does not price in a recession. Taking the average drawdowns in recessionary periods from previous all-time highs over the last five decades, the S&P500 would still need to decline by another 15%–20% to comply with precedents.
For now, the index keeps pricing in a bull market correction scenario. Interestingly, similar evidence can be gathered from fixed-income markets. Credit spreads have widened, but not to the extent that would be consistent with recessionary levels.
Spreads of investment-grade corporate, global high yield and emerging-market corporate are back at end 2018 levels, which merely signals an economic slowdown for now.
Big retail got caught wrong-footed
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The shares of US retailers dropped sharply after both Walmart and Target reported disappointing results and lowered their full-year profit guidance. The main culprit for the miss was input costs, particularly wages and transportation costs, running above expectations. In addition, a mix shift away from big-ticket purchases such as furniture and kitchen appliances to lower-margin grocery items amplified the gross margin pressure.
There are two developments at play. First, low-income consumers are increasingly favouring discounted items and have become more reluctant to make major purchases, as they feel the financial pain from higher energy costs and rising rents.
The second development relates to the consumption behaviour of mid- to high-end consumers, which also shifted. However, in this case, it was towards spending more on travel and leisure as pandemic restrictions were lifted. Apparently, US retailers did not anticipate the shift in consumer demand and were caught with excessively high inventories in those categories that benefited from the restrictions.
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In the case of Target, the markdown on these inventories explained a large part of the profit miss. Hence, we do not consider the margin pressure faced by these US retailers as a sign that US consumers are in trouble but rather that they are spending their dollars somewhere else these days.
The shadow-banking system warrants closer scrutiny
As per our continuous assessment, systemic risk remains dormant. The private sector in the US and Europe does not exhibit structural imbalances of the kind seen at the beginning of most recent recessions, as private agents have engaged in orderly deleveraging and repaired their balance sheets over most of the past decade.
To give credit where credit is due, regulators played their part in preventing excesses by taking commercial banks under their wing and imposing stricter capital and liquidity requirements. US private sector borrowing currently shows solid but not excessive growth, broadly in line with pre-pandemic trends.
However, there is a risk of regulatory arbitrage as nimble lenders try to find alternative, less constrained ways to provide easy money to willing borrowers to keep their businesses afloat, typically drifting into niche segments of the financial system where regulators have not yet intervened extensively.
In this regard, one area to examine more closely is the shadow banking system, including private markets. Should there be an imbalance hiding below the surface, we might find it where growth has been explosive as of late. Among the suspects is private credit, which averaged double-digit annualised growth over the past decade, ahead of other private market asset classes. The global private debt market has US$1.2 trillion ($1.64 trillion) in assets, which is expected to grow to a staggering US$2.7 trillion by 2026 alone.
Another area within private lending that deserves attention is the leveraged loan market. Leveraged loans are extended by non-financial corporations to private agents at the lower end of the credit rating scale and are hence associated with increased default risk. The S&P/LSTA (Loan Syndications and Trading Association) leveraged loan index, proxying US market size, totalled US$1.4 trillion as of February.
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Given the significant size of leveraged loan markets in both the US and Europe in the absence of tight regulatory standards, the European Central Bank issued a warning on potential financial stability risks as early as 2018.
In fact, the market size is likely to be even greater, as some direct lending with financing provided by non-financial corporations is only partially captured by existing data sources. We will continue our efforts to assess the ability of private debt to withstand a turn in the credit cycle and the associated implications for the health of the broader economy.
Portfolio construction remains key
We reiterate our view that it remains crucial to assess whether the liquidity drain in the financial system spills over into the real economy. In a highly financialised world, financial markets no longer reflect the real economy, but rather drive it; a phenomenon we call “the tail is wagging the dog”.
US households have accumulated unprecedented levels of equity-related wealth on their balance sheets since the onset of the Covid-19 crisis although this has mainly accrued to those with the highest incomes, with the top income quintile accounting for roughly 95% of all equity holdings on household balance sheets.
Given that these households also account for almost 40% of total US consumption, with a bias towards cyclical sectors, the impact of a negative wealth effect triggered by sharply tumbling equity-market values on consumption spending is undeniable.
At this juncture, however, some market observers do not see central banks coming to the market’s rescue until inflation has been brought under control. An argument recently made the rounds contemplating that the US Federal Reserve is no longer in the business of writing a put, but rather is writing a call option on the S&P500.
In other words, the Fed may have moved from supporting asset prices to depressing them by intentionally using negative wealth effects to reduce demand and thus fight inflation.
To be clear, the plethora of communications from Federal Open Market Committee members is anything but helpful in reducing complexity and discerning consensus among voting members. For our part, however, we do not believe the Fed put is dead.
While we do not know if and when the Fed will be deterred by a falling stock market, we do know that the price to be paid to the US economy if it does not step in is substantial. Temporary relief could come from a sharp correction in the oil price, which would ease pressure on low-income households burdened with high energy bills and allow the Fed to pause its tightening cycle. Should this scenario occur, a soft landing remains on the cards.
Confronted with a lack of visibility, however, we refrain from taking a strong position one way or the other, and further strengthen our barbell approach in the equity segment of our portfolios, selling our passive S&P500 investment while increasing our existing value-tilted positions. In combination with our existing tactical calls, which include biotech, Next Generation and Asian real estate investment trusts, we bolster portfolio construction with a more balanced exposure to equity styles.
Yves Bonzon is group CIO at Julius Baer
