As we head into the second half of 2022, inflation remains in the spotlight, but markets may already be looking one step ahead: a potential economic slowdown or impending recession. Experts point out that the levels of equity markets, fixed income or raw materials draw a scenario of slower growth. The week closed with significant drops in Nasdaq (-4%), in Europe of -2.4% and China continuing the recovery of levels (+1.65%). The semester leaves some levels not seen since 2020: Nasdaq -28.90%, SP500 -19.75% or Eurostoxx50 at 19%. The global fixed income index fell an average of -10%.
 
Although the probability of a recession is increasing, in the opinion of investment banks, they still do not see the possibility of a deep or prolonged recession. In this context, it is possible that the markets already value a shallow recession and that a gradual process of “bottoming out” has begun.
 
Equities: due to their level, they have discounted most of the recession.
Experts point out that the SP500 has closed the first semester with a fall of close to 20%, which they classify as a "bear market", being a sign that the economy is positioning itself towards a recession Since 1950, almost 70% of the bear markets have coincided with recessions. The economist teams forecast a recession in 4Q22/1Q23. An analysis of history -at the stock market level- shows us that the average historical returns of the SP500 before a recession are -27%, and in the current course, it is approximately -20%: this suggests, according to experts , that a large part of the adjustment to the recession has already been made, although some levels may be exceeded. Valuation (P/E) multiples typically trade at 13x-14x when entering a recession and are currently closer to these levels (from levels above 20x). What worries experts is that the analyst consensus has barely revised down its earnings per share expectations for 2022, which could weigh on the performance of equities.
 
Fixed Income: Yield Curves Flatten
While rates have risen sharply this year – in step with inflation and expectations of Fed action – they appear to have leveled off. The 10-year US Treasury bond, for example, hit a high of 3.5% in early June, but ended the month at 3.0%. This downward movement in rates is probably due to concerns about economic growth, and perhaps also to a “flight to quality” response on the part of investors (long-term rates being contained, which I could say according to the experts that the economy is not yet ready for big changes…). On the other hand, the so-called "curve inversion" of interest rates is consolidating more strongly. And this is due to the fact that now, short-term rates are rising stronger than long-term rates. Historically, according to experts, when it is invested, it is considered a sign of slowdown / recession (however, this situation must be given time to mature so that it can be confirmed). But they also consider that this drop in long-term rates indicates a moderation in inflation in the future. And this is discounted, the 5-year future inflation curve.
 
Commodities: world demand could relax.
The energy sector and raw materials have reached historic levels in less than 18 months. But lately, experts point out that we are getting to see the markets for raw materials relax again (industrial metals, agriculture, and even energy).
From a theoretical point of view, according to his point of view, central bank decisions do not usually directly affect commodity markets. But as the Fed and other central banks raise rates to fight inflation, commodity markets may reflect concerns about slowing growth and weakening demand due to higher funding costs. In short, prices fall, because "financing" becomes more complex.
 

CONCLUSIONS:
 
As the previous article indicates, there is a general consensus with the idea that the market needs a significant readjustment of the profit expectations of the companies, since they still remain little changed (despite rising prices and higher financing costs). ), but the question is whether a “free fall” of companies would be allowed to last over time, taking into account the period that is currently going through (reconciling the effects of a pandemic, unprecedented fiscal and monetary intervention, a war in Europe and galloping inflation, the whole cocktail at the same time...).
 
On the other hand, the arguments against a lasting recession are also valid with a labor market that is still at record lows for unemployment in the US and in Europe, still recovering. The Fed has been very clear about its commitment to curb inflation, and while it may be unmoved by falling stocks (not its focus), a job-killing job can quickly change its tune. Some companies are beginning to be seen announcing plans to curb hiring or downsizing. The technology sector in the spotlight, but lately it has begun to appear in other sectors.
 
Is there light at the end of the tunnel? Analysts invite or not to ignore the technical aspects discussed above, and some of the improvements that have been seen in recent weeks. Case in point is China: China is in a better position today than it was a few months ago, while positioning and sentiment remain near record lows (investment contrarian), with the economy poised to take off better after hundreds of adjustments and locks. The central banks have started this phase of “transition and adjustments” and the desired level of growth remains in their hands; finding the balance will be key, but without being able to make mistakes in the process. At this point, experts recall that history indicates that after market lows, recoveries 12 months later are usually relevant; avoiding extremes in decision-making, especially when the level of panic is very high, is the key to recovering ground.

 

July 2022.