To Recession or Not to Recession

By Crest Capital Advisors on July 8, 2022

Dow: 0.77% to 31,338.15
S&P 500: 1.94% to 3,899.38
Nasdaq: 4.56% to 11,635.31
Russell 2000: 2.41% to 1,769.36
10 Year Yield: 3.08%
Outperformers: Communication Services 4.92%, Consumer Discretionary 4.55%, Tech 4.32%
Underperformers: Utilities (2.87%), Energy (2.39%), Materials (1.48%), REITs (1.00%)

US equities were up for the holiday-shortened week, with the S&P and Nasdaq each notching five-session gain streaks through Friday trading. Growth was a big outperformer versus value as technology staged a large bounce leading the NASDAQ to more than double the return of the S&P 500. Treasuries were weaker with the curve flattening, but yields rose for three straight sessions through Friday. Oil was lower, with WTI settling down 3.4% (and trading as low as $95.10/barrel on Wednesday) amid rising recession concerns. It was a relatively uneventful week, with investors awaiting the start of the Q2 earnings season and continuing the debate about the Fed’s hiking path and the likelihood of a recession. While the idea of a looming slowdown seemed to take hold, especially given the pressure commodities faced this week, there were still a fair number of bright spots in the narrative. The commodity pressure was also considered supportive of the peak inflation thesis (making next week’s June CPI report even more anticipated).

The Wednesday release of the minutes from the June FOMC meeting met expectations for a somewhat hawkish tone, with members focused on bringing inflation down and commenting that elevated inflation levels could become entrenched should the Fed fail to act decisively. There was also a recognition that “an even more restrictive” stance could be necessary if price pressures persist. The minutes helped solidify the already firm expectations for a 75 basis point hike at the July 26-27th FOMC meeting, as did explicit endorsements of such a move this week during speeches from Fed participants Waller, Bullard, and Bostic.

The most anticipated economic report for the week was the June nonfarm payrolls on Friday which came in at 372,000, well above the consensus for 275,000. The bulk of the gains were in professional/business services, leisure/hospitality, and healthcare. The unemployment rate held at 3.6% as expected with the labor-force participation rate little changed, coming in at 62.2%. The stronger than expected headline reading adds credence to analyst views that the labor market is holding up despite building recession fears. Can we have a recession if nobody loses their job?

First Half Post Mortem

More and more data kept flowing across our desks this week providing analysis and insight into the extreme market performance of the first half of 2022. We felt some of this was compelling enough to devote one last commentary. After all, we just lived through one of the worst 6 month periods for stocks and bonds in modern financial market history. But perhaps more interesting is to look at prior extreme negative periods and extrapolate what might happen next. And in that, we have some historical precedent that just might suggest the second half is likely due for a significantly better experience.

First, we find it notable as you’ll see in the table below that we just experienced the worst start to a calendar year for a 60/40 portfolio (That’s 60% stocks, 40% bonds) in the last 45 years!

And this was really due to the fact that bonds did not act as a diversifier in a risk-off environment as they have for much of the last 4 decades. Instead, bonds are on pace for the worst year in history. The first-half loss of the benchmark was -10.4%! See the table below.

Of the 186 quarters since 1976, a negative quarterly return for both stocks and bonds has occurred just 20 times including the second quarter of 2022. Furthermore, over the same period, there are just five instances where both stocks and bonds are negative for two consecutive quarters. In all instances, the stock market was higher 12 months later.

And finally, this data came to us courtesy of First Trust. In the 5 prior periods where we experienced first half calendar year declines like we’ve just gone through, the market made gains for the rest of the year. The average gain was 23.78%.

Recession Talk

Recession talk is now approaching shutdown levels. Talking about it doesn’t make it so, but it doesn’t help either. The Bloomberg story count for the word “Recession” has exploded higher over the past two weeks. Perhaps the yield curve inverting once again is driving some of this news. However, the latest reading now exceeds what was seen in the back half of 2019 when the curve inverted. Furthermore, it is not far from the peak seen during the shutdowns in 2020.

Peak Inflation

The peak inflation story as of late is being driven by a broad-based decline in commodity prices from their recent highs. While most of the commodities on our dashboard are down more than -15% from the highs, the majority also remain well above where they were pre-covid. In particular, Food and Energy related commodities (inherently the most volatile) are up the most.

Will Powell Take Yes For an Answer?

As long as the outlook remains cloudy, long-term Treasury yields should remain relatively low. In fact, albeit volatile, ten-year yields are quite a bit lower than they were just a few weeks ago. The market knows that the Fed can’t raise rates a lot without causing a further slowdown and possibly a recession, and a slowdown would prompt the Fed to be less aggressive in the name of preventing a serious deterioration in the labor market. As a result, we would expect Treasury yields not to increase much from current levels unless the outlook improves significantly. If a recession is indeed in the cards, we would expect long-term yields to outright drop from here.

The unqualified good news in all this is that the market expects inflation to subside. Breakeven rates have declined a lot recently and in fact, account for the bulk of the recent decline in Treasury yields. Normally, we would caution that breakevens are poor proxies for inflation expectations because of embedded risk and liquidity premiums, but these days it is the “pure” inflation expectations component of breakeven rates that’s coming down fast (see chart below). Evidently, the market believes that aggressive Fed hikes are likely to have the desired effect on inflation. Lower inflation expectations are no doubt encouraging to the Fed; if the trend continues, it might lead to a slower pace of rate hikes, which would be of course bullish for risky assets.

Crazy Stat(s) of the Week

Here are this week’s crazy stats:

As we just celebrated July 4th and inflation being a consumer focus, we thought it worthy of perspective. In 2017, the average spend per person on July 4th was $73.42 and just last year was $80.54. This year, the average spend was $84.12 which is a 14.5% increase from 2017 and a 4.44% increase over last year. A family of 4 today, is spending $42.80 more on July 4th celebrations than in 2017.
Following the S&P 500’s worst H1’s of all time (1932, 1939, 1940, 1962, 1970, 2022) the average FoH2 return is 23.78% — with a high of 56.21% (1932) and a low of 6.01% (1940)

Corporate Drama That Never Ends

Breaking as we go to print on CMD, in our favorite corporate drama, Elon Musk sent a letter to Twitter via an official filing formally notifying Twitter that “the holder” (Musk) is terminating their merger agreement. The courtroom drama begins.

Quote of the Week

“More is lost by indecision than wrong decision. Indecision is the thief of opportunity. It will steal you blind.”

-Marcus Cicero

Calendar of Events to Watch for the Week of July 11th

The big events for next week focus on inflation data coming in the form of CPI and PPI. In the early part of the week, we get data from Europe and then on Wednesday the focus shifts to domestic inflation data as we get US June CPI on Wednesday and June PPI on Thursday. Following the strong employment report from this past week, a close eye will be applied to these reports to determine if the Fed’s interest rate hikes are having some impact to cool the inflationary pressures in the economy. The Friday reports of retail sales and consumer sentiment will also provide a look into how the US population is adjusting to the higher costs and whether purchasing habits are being altered by having to prioritize what to buy.

Monday 7/11 – No major economic reports will be released.

Tuesday 7/12 – The Eurozone countries report their CPI data with the focus being on Germany and France. For the US, we receive an update on US small businesses with the NFIB Business Index.

Wednesday 7/13 – The headline economic report of the week with the US CPI report will be released. Economists are expecting a print of 8.8% which is above May’s 8.6% run rate and will have an impact on market forecasts for what the Fed might do during its July 26-27th meeting. The Core reading (ex food and energy) is forecasted to be 5.7% down from 6.0%.

Thursday 7/14 – Following the Wednesday CPI report, the US will report PPI (Producer Prices) for the month of June which is a leading indicator of inflation pressures. Economists are expecting the headline number to be 10.8% which would be flat to May’s print.

Friday 7/15 – Retail sales for June will lead a series of reports which also include industrial production, business inventories, and consumer sentiment.

Source: FactSet