Various methodologies indicate an increasing—though still moderate—probability of a recession in the short term
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Yield curves continue to indicate a moderate risk of recession
The 10y2y yield curve briefly inverted in early April and flirted with inversion more recently, as the market digested new information that the Fed was planning to accelerate the monetary normalization cycle. However, the curve has since steepened again, while the 10y3m curve maintains a positive slope of 170 basis points.
Corporate spreads imply a low probability of a recession
IG US spreads have widened to 145 basis points over Treasury bonds. The average level of IG spreads during recessions (the last six) is 250 basis points, and the average level outside of recessions is 100 basis points.
Meanwhile, U.S. high-yield spreads have widened to 500 basis points over Treasury bonds. This compares with an average high-yield spread during recessions (over the last three) of 1,000 basis points and an average spread outside of recessions of 350 basis points.
In both cases, spreads are around their long-term averages and still imply a low probability of a recession.
Equity markets continue to price in a high risk of recession, unlike credit markets
Many of the fears of a recession stem from the stock market correction. The S&P 500 has fallen 23.5% so far this year, entering a “bear market.” The probability of a recession implied by this factor stands at 90%; however, this must be weighed against other market and macroeconomic variables, which point to a more limited risk of recession.
Furthermore, much of the correction in the equity market can still be attributed to a “compression of multiples” resulting from higher interest rates driven by inflationary pressures, while corporate earnings expectations remain resilient.
High inflation is forcing the Fed to abandon its countercyclical policy, which could lead to a recession
We already know that the median decline in the S&P 500 around recessions has been 26%. The exceptions, of course, correspond to corrections following “excesses” or bubbles, such as the dot-com bubble in 2001 (-49%) and the 2008 financial crisis (-57%). However, the closest parallels to recessions triggered by inflationary shocks can be found in the 1970s and 1980s.
During periods of inflation, the Fed was forced (as it is now) to adjust policy in a more procyclical manner, and in all those cases, the U.S. economy ended up in a recession. This explains why it is less likely today that the “Fed will eventually save the market,” since, if the Fed is determined to bring inflation down to its target, it will likely cause significant economic pain first.
Of course, it’s valid to ask how much the current situation resembles other periods of stagflation (such as those in the 1970s and 1980s) that ended in recession. The truth is that, for now, very little.
The comparison would only make sense if one believed that inflation would remain at current levels—or even higher—not only in 2022, but also into 2023 and beyond. As a point of reference, the recession that began in 1973 and lasted until October 1974 (with a drop in the S&P 500 of -48%), occurred during a period of inflation that lasted a couple of years (oil prices, for example, quadrupled), during which inflation even exceeded double digits, just as it did in the early 1980s (the economy had just weathered two oil shocks, in ’73 and ’79), leading the Federal Reserve Board, headed by Volcker, to raise federal funds rates—which had averaged 11.2% in 1979—to a peak of 20% in June 1981.
… but not in the style of the '70s or '80s
It’s true—the likelihood of a recession is increasing. Fed Chair Jerome Powell himself said as much this week before the U.S. Congress, noting that a recession is a “possibility.” So, there are two important questions: When will the economy actually fall into a recession? And how deep would it be?
Judging by the performance of equities, a recession would seem imminent. But that probability doesn’t even exceed 50% in the various models, although it is higher after 12 months. This is relevant because assets tend to remain profitable even prior to a recession, even with an inverted yield curve—which isn’t even the case here. Therefore, it would only make sense to reduce risk if we were highly convinced that a recession is imminent—which is not our base case. The situation is different looking ahead to 2023, assuming inflation does not subside.
As we noted at the beginning, yield curves continue to point to a moderate risk of recession. This is in contrast to the 1970s or 1980s, when the yield curve inverted by as much as 200 basis points.
Returns following previous bear markets have been favorable
The S&P 500 has now fallen more than 20% from its high, meeting the typical definition of a bear market.
Previous episodes involving a decline of at least 20% yielded favorable results over the following 6.5 months (through the end of the year).
The median return in the year following previous bear markets was 23%, while extending the holding period to 24 months resulted in a return of 32%.
These relatively rapid recoveries highlight the potential cost of selling stocks after they have already suffered a significant decline.
Opportunities in fixed income while maintaining high credit quality and a “more neutral” duration
Interest rates already seem “more attractive,” especially in the IG segment, with spreads at historical averages.
We recommend gradually increasing the duration with the goal of returning to “more neutral levels” over the course of about 4 years.
Ultimately, it all comes down to inflation
Generally, stock prices have declined in the months leading up to previous inflation peaks.
However, those losses were generally reversed over the following 12 months, especially if the U.S. avoided a recession during that period.
The higher-than-expected May CPI reading implies a subsequent peak in inflation and less room for stocks to recover in our base-case scenario.
