Different methodologies show an increasing, but still moderate, probability of recession in the short term.
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Yield curves continue to indicate moderate risk of recession
The 10y2y yield curve inverted briefly 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 subsequently steepened again, while the 10y3m curve maintains 170 bps of positive slope.
Corporate spreads have an implied low probability of recession
US IG spreads have widened to 145 bps over Treasuries. The average level of IG spreads during recessions (the last six) is 250 bps, and the average level outside the recession is 100 bps.
Meanwhile, HY US spreads have widened to 500 bps over Treasuries. This compares to an average recession level of HY spreads (over the last three) of 1000 bps and an average off-recession level of 350 bps.
In both cases, spreads are around their long-term averages, and still have a low probability of recession implied.
Equity markets continue to price in high recession risk unlike credit markets
Many of the recession fears stem from the adjustment in equities. The S&P 500 has fallen 23.5% so far this year, entering a "bear market". The probability of recession implied by this concept reaches 90%, which, however, has to be weighted by the rest of the market and macroeconomic variables and which show a more limited recession risk.
Moreover, much of the equity adjustment can still be attributed to "multiple compression" due to higher interest rates resulting from inflationary pressures, while corporate earnings expectations remain resilient.
High inflation forces Fed to abandon countercyclical policy, which could end in recession
We already know that the median decline of the S&P 500 around recessions has been 26%. The exceptions, by the way, correspond to reversals of "excesses" or bubbles such as the dot.com in 2001 (-49%) and the 2008 financial crisis (-57%). However, the closest references to recessions induced by inflationary shocks can be found in the 1970s and 1980s.
During inflationary times, the Fed was forced (as now) to tighten policy more pro-cyclically, and in all those cases the U.S. economy ended up in recession. It follows that today it is less likely that the "Fed will eventually save the market" because, if the Fed is determined to bring inflation down to target, they are likely to cause a lot of economic pain first.
Of course, it is valid to ask how much the current reality resembles other stagflationary periods (such as the 1970s and 1980s) that ended in recession. The truth is that, for now, very little.
The comparison would only make sense if one subscribed that inflation would remain at current levels and higher not only in 2022, but also in 2023 and beyond. For reference, the recession that started in 1973 and lasted until October 1974 ( with the S&P 500 dropping -48%), was framed in an inflationary period of a couple of years (oil prices, for example, quadrupled), where inflation even exceeded 2 digits, as in the early 1980s (the economy was coming off two oil shocks, '73 and '79) and which led the Federal Reserve board, led by Volcker, to raise federal funds interest rates, which had averaged 11.2% in 1979, to a high of 20% in June 1981.
... but not in the style of the 70s or 80s.
That's right, the odds of recession are increasing. Fed Chairman Jerome Powell said so himself this week in the U.S. Congress, noting that a recession is a "possibility". So, there are two important questions: When will the economy actually fall into recession? How deep would it be?
Judging by the behavior of equities, a recession would be imminent. But that probability does not even exceed 50% in the various models, although it is higher after 12 months. This is relevant because assets are often even profitable prior to a recession, also with an inverted yield curve, which is not even the case. Therefore, it would only make sense to forgo risk if we had a high conviction of an imminent recession, which is not our base case. It is different around 2023, if inflation does not recede.
We noted at the beginning that yield curves continue to indicate a moderate risk of recession. This compares to the 1970s or 1980s, where the yield curve inverted as much as 200 bps.
Yields after previous bear markets have been favorable
The S&P 500 has now fallen more than 20% from its peak, meeting the typical definition of a bear market.
Previous episodes of at least a 20% drop showed favorable results during the following 6.5 months (the equivalent until the end of the year).
The median return in the year following the previous bear markets was 23%, while extending the holding period to 24 months resulted in a return of 32%.
These relatively quick recoveries highlight the potential cost of exiting stocks when they have already suffered a significant decline.
Opportunities in fixed income while maintaining high credit quality and "more neutral" duration
Rate levels already look "more attractive", especially in IG, with spreads at average levels for its history.
We recommend gradually increasing the duration with the objective of returning to "more neutral levels" around 4 years.
Ultimately, everything depends on inflation
Stocks have generally declined in the months leading up to previous inflation peaks.
However, those losses generally reversed over the next 12 months, especially if the U.S. avoided a recession during that period.
The upside surprise in the May CPI implies a subsequent peak in inflation and less room for stocks to rally in our base case.
