Inflation, and the Federal Reserve’s response to it, remains the primary concern of market participants. The longer inflation stays high, the more work the Fed must do via interest rate hikes, which increases the risk of recession.
Wednesday’s release of June consumer prices showed consumer inflation accelerated to 9.1% last month, which adds pressure on the Fed to act even more aggressively than they have been. Considering this raises the risk of recession while stocks have already entered bear market territory, the question becomes: How much recession risk is already baked into stocks?
The Consumer Price Index (CPI) jumped a larger-than-expected 1.3% in June. The increase was broad-based across CPI categories, with energy a big part of the story. Core CPI, which excludes energy and food, increased 0.7%, the most in a year, and above the consensus estimate. Shelter—which is more than 40% of core CPI— increased 0.6% with rents up 0.8%, the most since April 1986, and owners’ equivalent rent up 0.7%, the most since June 1990. On a y/y basis, headline CPI inflation hit 9.1%, a new high since November 1981 and above the consensus of 8.8%. Core inflation eased modestly to 5.9% y/y from 6.0% y/y in the previous month, and above the consensus of 5.7% y/y, but is still near its highest level since 1982.
From its all-time high on January 3rd to its recent low of 3,667 in June, the S&P 500 declined by 24%. Since 1950, there have been 11 previous bear market episodes. After entering a bear market, the index typically fell for an additional 1-2 months before reaching a trough. The median peak-to-trough decline during these bear markets equaled -34%. In the 4 bear market episodes that were not followed by a recession within the subsequent 12 months, the median 6-month return after falling into bear market territory was +16%. In the remaining 7 episodes that were followed by a recession, the median 6-month return for the index was -7%.
Looking at the 12 recessions since World War II, the S&P 500 Index has contracted from peak to trough by a median of 24%, with an average decline of 30%. The Great Recession of 2008 represents the worst case, with a decline of 57% while the bursting of the 2000 stock market bubble was the second worst case with a decline of 49%. These two episodes drag the average down relative to the mean. We note the market sold off by 27% the last time the Fed fought a major inflation battle in 1981.
For the 12 recessions since WWII, the equity market has begun to price a recession on average 7 months prior to the official start of the recession per the National Bureau of Economic Research’s (NBER) designation. In all but one instance, the sequence of events was the same: The market peaked prior to the recession and then bottomed prior to the end of the recession.
Valuation does not appear to fully reflect a recession. The S&P 500 YTD decline has dragged the forward Price/Earnings valuation multiple for the index from 21x to about 16x, which is still above the 20-year average.
Earnings estimates have yet to factor in recession conditions, with the S&P 500 projected to see about 10% earnings growth in the next 12 months. In addition, every sector is expected to see earnings growth over the next 12 months. Looking across the 6 recessions since 1980, earnings declines vary significantly across sectors. The median peak-to-trough earnings decline for the S&P 500 was 19%. However, the defensive sectors actually produced earnings gains—Utilities (+9%), Consumer Staples (+5%), and Health Care (+4%). Communication Services (-1%), Technology (-4%), and Energy (-12%) outperformed the overall market’s -19%. The biggest earnings declines came from Materials (-56%), Consumer Discretionary (-44%), Industrials (-21%), and Financials (-20%).
To re-establish the market’s uptrend that existed until early this year, we think market participants will need to see progress in the inflation battle that the Fed is aggressively waging. Meanwhile, we continue to see leadership coming from the defensive sectors mentioned above. We currently favor our overweight-rated Health Care and Utilities sectors. We are also favorably neutral on Consumer Staples. In addition to relatively stable earnings growth, these sectors benefit from low betas (measures how much a sector moves for any given overall market move) with Utilities at 0.4, Consumer Staples at 0.6, and Health Care at 0.8.
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