Since When Does a Slowing Economy Mean Risk On?

11.22.2023 After suffering through one of the most aggressive tightening cycles, liquidity – the availability of money to borrow, spend and invest – is easing, as investors sense that rates have peaked. Fueling the slowdown narrative is a range of recent data including a weaker-than-expected employment report, tepid inflation data, and retail sales showing consumers cutting back on discretionary spending. Intermediate Treasury yields, which reached five per cent last month, cascaded below 4.5 per cent in response. The dollar, which was propelled earlier this year by higher overnight rates, also reversed course and slid more than two per cent. The shift inspired risk taking, with equities, particularly foreign, leading the charge higher. Does “risk on” make sense in a slowing economy?

We believe the moves we’ve seen in equities and bonds in the last month are both justified and sustainable. Most of the movement we’ve experienced in equities over the last two years was  almost exclusively attributed to market multiples and interest rates while earnings estimates have been relatively unchanged.  The reciprocal of the 10-year, BBB corporate bond yield is a good proxy for the equity market’s forward PE ratio, which fell to about 16x from about 22x at the beginning of 2022. The recent rate reversal helped push expected PE ratios higher, to about 17x.   

Going back to 1988, history suggests a positive, but slowing, growth environment combined with a positive, but slowing, inflation environment is modestly favorable for equity and bond investing while being slightly unfavorable for commodities. In such environments, equities have historically delivered a 3.1 per cent average quarterly return, while bonds ended 1.7 per cent higher and commodities retreated 1.1 per cent. 

While a slowdown narrative is our base case, we see two risks that could undermine equities and bonds: deteriorating earnings and unrelenting spending and growth. While earnings expectations have remained stable this year, the possibility of an earnings contraction associated with a hard landing could weigh on equity returns. Higher inflation and pricing power have helped companies deliver positive top and bottom-line results despite flat volumes. Same-store sales growth has expanded 3.4 per cent nationally through November 18, according to Redbook Research. Subtracting 3.2 per cent year-over-year inflation recorded through October suggests flat volumes. Any deterioration in price growth or pricing power would therefore dent corporate profits.

Continued discretionary spending, particularly among households aged 65 and over, is another concern that could undermine the economic softening scenario, push interest rates higher and keep the Fed tightening program in place. Never in our nation’s history has the 65+ population been this large relative to the rest of the population or nor represent as much spending power as today’s Boomers do. Since the financial crisis, however, households aged 65-74 now rank as the wealthiest among all age categories, thanks to higher values for real estate and financial assets. Their spending is largely insulated from the business cycle, including higher interest rates, because they tend to save and not borrow. They are also largely insulated from the job market, because many of them are retired. Americans aged 65+ accounted for 22 per cent of spending last year, according to The Wall Street Journal. It shouldn’t be a surprise that Carnival Cruise Lines (Ticker: CCL) is one of the best S&P performers this year. Continued spending could drive inflation higher and force the Fed to respond, pushing interest rates up and stock portfolios down.  Unlike other economic factors, it is wealth deterioration that would finally force the senior set to sit on their wallets.  

Bottom Line: We expect the slowing growth and inflation scenario to be modestly favorable for equity and bond holders. While it might not be noticeable on the surface, most of the S&P 500 is already in a bear market. Of the S&P ‘s 503 companies, 308 are trading more than 20 per cent below their peak: they represent 38 per cent of the blue-chip Index’s market cap. Nearly half of Index constituents are off more than 30 per cent from their peak. While deteriorating growth is not a bullish catalyst, most stocks appear to have already priced in a recession.