QVMM - Piecing Together The Recession Puzzle: The Implications For Markets

2023-06-22 12:58:00 ET

Summary

• How a recession could impact different asset classes.
• Why a recovery may be more U shaped than V shaped.
• Equity markets may not be telling the whole investor sentiment story.

The S&P 500 entered bull market territory recently, despite ongoing concerns about a potential recession. Jing Roy, Portfolio Manager at TD Asset Management, speaks with Greg Bonnell about whether investors should be considering different asset classes in the current environment.

Transcript

Greg Bonnell: There are plenty of concerns about a potential recession on the horizon. But despite those fears, markets have held up well. In fact, of course, the S&P 500, even clawing its way into bull market territory in recent days and weeks. So how should investors be eyeing different asset classes in this environment?

Joining us now to discuss Jing Roy, portfolio manager with TD Asset Management. Great to have you on the program. This is your first time. I'm really looking forward to it.

Jing Roy: Thank you. Glad to be here.

Greg Bonnell: So let's talk about this. Of course, we've been talking about a potential recession for so long now. And I can forgive people for asking the question, "So where is the recession?" But we've been living with the fears. How is this impacting different asset classes?

Jing Roy: So for the most-anticipated recession, we really have to squint really hard to see where the fear is manifesting in asset classes. So what I see is, we're seeing recession fear being reflected in the sovereign bond yields and in oil prices. But it's not really reflected in equity prices or credit spread. So let's take all these asset classes in turn and dive a little deeper into each one of them.

When we talk about the yield curve structure, the yield curve is deeply and extremely inverted for nominal and real rates in US, Canada, and eurozone. What it means is that in the future, people are expecting lower growth and lower inflation. So that's very bearish on the outlook.

So secondly let's take a look at the oil price, which is down 12% year to date, despite the very active effort for OPEC to manage the supply. But it follows the industrial production slump. We're seeing it in the US, eurozone, and in China.

Now, moving on to equities, it's not being reflected in the S&P 500 index in the US, for example. And there are a couple of reasons for that. Number one, it's important to remember that the equity index is very different from underlying economy. So for example, technology accounts for about a third of the index, but contributes only to about 8% of the GDP. So there's a disconnect there.

And secondly, it's very important to understand that the earnings growth expectation right now on the Street, it's a V-shaped recovery that people are expecting. So if you look at the S&P 500 Equal Weighted Index to take out the overwhelming dominance of the top seven tech names, Street is expecting about 10% earnings growth in each of the next two years, and that's compared to a recessionary scenario of negative 10% average. So earnings are not really pricing a recession.

And lastly, I think the risk appetite is really returning because the economy has stayed so resilient and the Fed is reaching the end of the hiking cycle. As a result of that, the left-tail risk has been taken out. So what you're seeing is that the equity risk premium, which is the extra compensation equity investors would demand to hold equity above a risk-free asset, has declined to a 15-year low.

And if you look at the VIX index, it's at a 30-year low. And if you look at implied volatility before major economic data releases, they have collapsed. So all these play into a bull narrative for equity prices.

And when you look at the credit spread, even though bond investors typically are less bearish than equity investors, but the recessionary fear is not there, either, because if you look at the high-yield indices, the default rate implied from the high yield credit spread is about half of what we typically see during recession. And the recovery rate is a third higher than what we typically see in a recession. So overall, asset prices are pricing a no-landing situation.

Greg Bonnell: No-landing situation. That was a fascinating breakdown across asset classes. What about across geographies as we've been living with these storm clouds on the horizon that never seem to appear?

Jing Roy: So in the US, as we detailed in the previous section, there is no landing. The tremendous amount of fiscal stimulus really propped up the corporate profits and consumer spending. So that's about 18% of the GDP by IMF estimates. So we're still working through that.

Across the pond in eurozone, it's even more dramatic. Technically, the eurozone is in a technical recession. But the equity price there has actually outperformed the US year to date, and because the equity company over there is more indexed to the US growth, export growth, and also the fact that they're cheap beneficiaries of the major energy transition fiscal spending. I think when we come back home the mood is a little somber in Canada because cyclical sectors actually make up over half of our index here. So what we see is the equity return actually factoring a pessimistic view of the economic growth in Canada here.

And the situation is even more dire in China. The sentiment is undoubtfully very, very bearish there, because in the short term, the growth coming out of the rebound coming from the COVID lockdown is petering out. And in the longer term, people are focused on the deleveraging and balance sheet risk that can cause long-term stagnation without proper policy support.

And one outlier in the developed market is really Japan. Over there, the central bank policy is extremely supportive because its prerogative is really to support the economy to be relaunched to a sustainable 2% inflation target. As a result, the monetary policy is very, very easy. And you're seeing expansion in service PMI, and also a recovery in manufacturing.

Greg Bonnell: When you said no landing, does it take us to the mythical place where you just don't have a recession? I mean, should we be expecting an economic pullback of some sort? What would it look like? What is the shape, the size?

Jing Roy: Well, there are lots of alphabets available to describe a shape of a recession. So if I have to pick one, it will be a U-shaped one. What does it mean?

It basically says the recession will take longer to play out because it will be a credit-led cycle. And during this cycle, this recession typically will have to take time because the interest rates have to stay higher for longer for this narrative to play out. It really comes to the point that how long companies and households can withstand the high interest rates without cutting back consumption.

So the first domino to fall is really the corporate sector because they have higher interest rate sensitivity. About a third of the corporate debt is on floating rate. So how it will play out is that corporate profits are impacted by the slowing growth and higher financing costs, which compel them to cut demand for goods and services, as well as labor. And for those who have been flying too close to the sun, they will have to resort to distressed asset sales to shore up balance sheets.

And some of them will not make it and declare bankruptcy. And then this corporate malaise will spread to the household sector through unemployment, which will ultimately impact consumer consumption. And this feeds right back into corporate profitability, and it creates a kind of downward spiral and reinforcing narrative for the economy.

So that's how the anatomy of this recession will play out, but it will be a long game. It will take time to play out. And we're already seeing some signs of weakening.

In the corporate sector, for example, we're seeing bankruptcies rising among private firms, because they mostly rely on regional banks for credit. And the credit condition there has been fairly tight. And we're also seeing that consumer spending has started to weaken, especially among the lower-income consumer groups. And the delinquencies for car loans and credit cards have started to tick up among these income brackets.

Greg Bonnell: Once you get in a situation like that -- a recessionary situation, obviously, it makes a lot of sense. Corporations are noticing weakness in the economy. They lay people off. People go home and say, well, I'm not buying that thing from these corporations. I don't have a job. But what does it mean for fixed income? What does it mean for equities?

Jing Roy: Let's take fixed income first. If the rate has to be kept for higher and longer, then the long-term US bonds, treasuries will outperform IG credit, which will, in turn, outperform high-yield credit. So let's break it down one by one, because in a U-shaped recessionary scenario, growth will slow down.

So if you think that the real growth and inflation expectation will decline by, let's say, 25 basis points, conservatively speaking, for each, that's a 50 basis point of decline in nominal yields. That can translate to about 10% of upside for those long bonds. And that's on top of the 3 and 1/2% of yield you're collecting just from coupon alone. So when you put that together, you're getting equity-like mid-teens kind of return, which is quite attractive.

And moving on to IG credit, what's interesting is that at the front end of the curve, because the curve is deeply and extremely inverted, you're getting very attractive carries, especially for high-quality credit. As a result of that, that specific slice of the IG credit market is very attractive. However, for high-yield, the credit spread will widen, more so than for IG credit.

And the outcome will be non-linear, so we're cautious towards high-yield credit at the moment. So the key here is really to construct a fixed-income portfolio that's defensively positioned, stay with defensive qualities, and stay with quality. At the same time, you have to maximize the carry. So moving on to --

Greg Bonnell: The equity side, like stocks, S&P 500 entering a bull market despite all these concerns we had entering the year. Some people are scratching their heads.

Jing Roy: Yeah, for equities, it's a little -- it's not one kind of recipe to fit all. So what I would start is, point number one, it's very hard to rely on macro, specifically interest rates, to propel the valuation multiple any higher, especially given the fact that the equity risk premium is at such low level. So the room of valuation, multiple expansion is quite limited, unless the Fed starts to cut rates, which we are not expecting for quite some time. So as a result of that, this is a very good environment for stock pickers who can identify companies with underappreciated earnings growth and free cash flow growth. As a result of that, you will look for managers with good stock-picking abilities.

And the second point I want to make is that the factor rotation within the equity market will become more frequent and harder to trade. And factor rotation typically corresponds to changes in financial conditions. And we're expecting more frequent changes in financial conditions, just because the Fed is data-dependent. And that results in a delay for the Fed to calibrate the Fed funds rate to the prevailing economic growth and inflation dynamics.

As a result of that, you can have temporary loosening of financial conditions when economic data is weak, but tightening financial conditions when the economic data is strong. As a result of that, you're seeing oscillating financial conditions, but we know that the end result is tightening financial conditions. The path is uncertain, so we have to really zoom out.

And the key is to focus on the long-term trajectory and stay with quality companies that have profitable business models, strong cash flow generation capabilities, and [at] the same time have a very strong balance sheet to weather the higher cost of capital, and at the same time have a very shareholder-friendly dividend policy.

And the last point I want to make is, because there is widening policy divergence across the globe in terms of monetary policy and fiscal policy. So to increase the diversification of your equity portfolio, it will now make sense to look abroad, outside of the US, to see regions whether there are regions that are more supportive fiscally and monetarily to support that economic growth.

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