Co-Head of Investments and Managing Director Ben Kirby reviews 2022 to-date and looks at the chance of recession and the relative value of ex-U.S. markets.
Observations in Equities: Recession Fears Shadow the Stocks
I’m Ben Kirby, co-head of investments at Thornburg Investment Management. As we look back, there was nowhere to hide in the first half of 2022. Bonds were down roughly 10% and stocks down around 20% in most regions. Value stocks were down less than growth stocks this year, and dividend-paying equities have been most resilient.
Reflecting a flight to safety and rising US interest rates, the dollar strengthened by over 10% in the last 12 months and briefly touched parity with the Euro for the first time since 2002. Commodity prices surged in the first quarter, driven by the war in Ukraine, but fell in the second quarter. Energy prices remain higher than at the start of the year, but agricultural commodities and base metals weakened in the second quarter. For most Americans, their best performing asset in 2022 has been their home, up 20% in the last year.
After fretting about inflation through most of the year, markets are now oscillating between worrying about inflation or recession. Of course, it’s possible to have both high inflation and a recession, that is stagflation, but this situation is unlikely. While the debate is unsettled, increasingly the market is becoming comfortable with expectations that inflation will moderate as commodity prices have declined in the last few months, long term inflation expectations remain well anchored and falling money supply should curtail excess demand for durable goods. The question going forward, however, is whether inflation will moderate to a level the Fed is comfortable with, near its 2% target. As of now, we don’t expect inflation to slow to anywhere near that mark. Rather it’s far more likely that inflation slows to about 4-5%, leaving the Fed frustrated and inclined to tighten further.
On the other hand, as evinced by falling long duration U.S. yields, and the yield curve inverting, the market is increasingly worried about a recession. While we would not be surprised to see the U.S. tip into recession, we think there are indications it could be a shallow slowdown and should not lead to a financial crisis. One reason for optimism is that the U.S. consumer, who accounts for the bulk of GDP, is still robust. The labor market remains incredibly tight – wages are rising, there two job openings for every one job seeker, and consumer debt ratios are 34% lower than they were in 2008. We also observe that corporate interest coverage ratios are healthy and bank leverage ratios are appropriate. In sum, we do not see the financial excess that would lead us to worry that an economic slowdown will spawn a financial crisis.
Despite rising worries about a recession, corporate earnings growth has been surprisingly robust year-to-date. We think expectations for the back half of the year are aspirational, as during the summer reporting season the tone of calls has been more bearish than usual. Moreover, global firms are dealing with dollar strength which acts as a headwind to overseas-generated revenue growth. As a rule of thumb, if GDP growth contracts by 1%, then profits should decline about 15%. We compare a potential 15% earnings contraction with a current expectation of high single digit growth, and we think stocks may be trading at higher forward earnings multiples than they should to be.
Looking outside the U.S., Chinese GDP grew by just 0.4% in the second quarter as the economy was battered by Covid lockdowns. China is critical to global growth as it remains the world’s second-largest economy. Chinese economic activity should reaccelerate in the second half of the year, but at this point, the government’s 5.5% growth target looks unattainable. We expect China to respond with several economic stimulus measures, which will serve as a growth impulse in the second half as the rest of the world slows down. Still, non-U.S. equities are at a steeper-than-normal discount to U.S. stocks. This valuation discount coupled with a historically strong U.S. dollar may portend a period of excess returns for international stocks relative to domestic.
We welcome periods asset price volatility, in which it becomes challenging to separate the signal from the noise for most investors. As fundamental investors, we focus on corporate earnings and guidance. We marry our fundamental analysis with a risk management framework that helps us to minimize unnecessary volatility and build balanced portfolios that can perform in a variety of environments. These times provide us additional opportunities to add long-term value for clients through active management. Thank you and see you next quarter.
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