The rate shock we experienced in 2022 cannot be understated. To put it into perspective, the expectation for rate hikes going into the year was 75 basis points (bps), and the Federal Reserve (Fed) proceeded to move rates 425 bps, or five times the expected change. This has led to a massive repricing of assets, particularly those where valuation is highly sensitive to interest rates. Some of these assets and funds with high exposures look like a city after wartime destruction.
Alongside peak-to-trough drawdowns of -25% in the S&P 500 index and -35% in the Nasdaq 100 Composite, the risk repricing of 2022 amounted to the third largest annual drawdown for the 60/40 portfolio since 1927. That is what we call an outlier.
Investors have now attempted to price the aftermath of a militant-style Fed response function to inflation, a situation that continues to involve a very wide range of potential outcomes.
One of the more common expectations we hear from the media and pundits is that of an economic recession. For those who were around for the beginning of the last cycle, the word can conjure up memories of the financial system on the brink of collapse, a doubling of the unemployment rate with persistent joblessness of skilled workers, and a household deleveraging cycle that lasted for 6 years. Yikes. Paint It, Black.
A Note on Risk Premiums
Intriguingly, among the rubble of last year’s interest rate blitzkrieg is a completely different set of risk premiums available to investors:
- The one-year real interest rate is now above 1% for the first time since 2007.
- The yield on investment grade corporate bonds climbed from 2.4% to as high as 6.1%, eclipsing the earnings yield on large cap equities temporarily for the first time since 2009.
- The yield on high-yield corporate bonds climbed from 4.6% to as high as 9.9%, a level which over the last 20 years has been offered to investors momentarily only four times: the March 2020 pandemic crisis, the 2015 corporate earnings recession, the European debt crisis and the Great Financial Crisis (GFC).
Capitalism requires the existence of an investment risk premium, otherwise there would be no incentive to give our hard-earned savings to the cash flow machines that want to fund their projects. For the last decade, that risk premium had been artificially suppressed by post-GFC accommodative monetary policy. It is now more attractive, which indicates a greater incentive for people who want to invest their savings for a future expected return.
A Note on Stocks
The earnings yield on equities isn’t quite at that post-crisis 8% level, but at 5.2% it sure beats a year ago 3.1% and is right in line with the average back to 1990. As we’ve discussed for over a year, the environment of higher inflation and interest rates was bound to create a valuation comeuppance for the most dearly valued growth stocks. The return to fundamentals continues to demand an active approach to equities as some industries brace for slowdown while others see profit growth ahead.
A Note on Recessions
The risk of economic recession is a part of the distribution of outcomes, but we’re going to have to see an increase in joblessness. The chart below shows recessions and the monthly change in nonfarm payrolls. As illustrated, every recession recorded back to 1939 coincided with multiple months of job losses. We’ve been hearing the headlines of layoffs across small and large technology and financial firms, but in many cases the larger companies are offering multiple months of severance to carry over individuals to their next job. With over ten million job openings and counting, the labor market appears able to absorb at least some of the talent.
The last chart below adds the history of the ISM Services New Orders Index, a leading diffusion index which captures the sentiment of new order flow for purchasing managers in the services sector. The index plummeted from a level of 56 (expansion) in November to 45.2 (contraction) in December. At the same transition from expansion to contraction in services business sentiment in April 2001, the economy had already been losing jobs and on net added only 112 thousand jobs in the previous six months. At the same inflection point in January 2008, the economy had added 365 thousand jobs in the previous six months and the very next month began a 21-month job losing streak totaling over eight million jobs. Over the last six months, the economy has added over 1.8 million jobs and is expected to add 183 thousand more in January.
The hiring dynamic can certainly change, and we’re paying close attention, but the secularly tight labor market appears to be keeping a proper self-reflexive recession from happening in the near term, supporting the incentive to remain invested at the current more attractive risk premiums in the aftermath of one of the largest rate shocks ever.
Important Disclosures & Definitions
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
ISM Services New Orders Index: Shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. A reading over 50 shows orders have risen from the previous month while a reading below 50 shows a decline in orders.
AAI000177 3/31/2024
