07 Jun 2022 4 min read

Have equities already bottomed out?

By Lars Kreckel

Following the dismal year-to-date performance of the US equity market, we consider whether recession risk has already been priced in.

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In recent weeks, recession has become the dominant market topic. But beyond market chatter, how much recession risk is already priced into US stocks? This is impossible to answer with certainty, but there are a few things we can examine to get a rough idea.

Equities never lend themselves to precisely isolating the effect of any single factor, but nevertheless the 18% drawdown in the S&P 500 in the year to date is about half the average post-World War II bear market drawdown[2]. The price-to-earnings (P/E) decline is closer to 75% of the average[3], but P/E declines are by their nature more front-loaded.

While equities have fallen as one would expect heading into a recession, albeit far earlier than normal, bond markets have not followed the normal pre-recession playbook. US Treasury yields have on average declined 120 basis points (bps) in the six months before post-World War II recessions; this time around, they remain close to multi-year highs.

For recession-pricing in equities, cyclical stocks’ performance relative to defensive (or non-cyclical) stocks is a better gauge, in our view. The pattern of cyclicals’ underperformance so far is pretty similar to that before the last two recessions. But the extent of the underperformance is still only about a quarter of that suffered during those recessions.

Unpicking the equity market decline

How much recession risk is already priced in? I would put more weight on the recession pricing in cyclicals than the overall equity drawdown indicates. I would ascribe a lot of the equity correction to the sharp increase in bond yields, and the many factors behind that.

As a result, the starting point for pricing in a full recession is that equities have already de-rated a long way from their highs; sentiment is already bearish before most of the recession pricing might happen. We believe the additional decline that would be required at the index level may be smaller than would often be the case, but the adjustment in cyclically sensitive stocks within the equity market would likely still have a long way to go.

In summary, my view is that less recession risk is currently priced in than the headline equity decline suggests.

Equities: the longer-term outlook

When markets are volatile, it’s easy to spend a disproportionate amount of time discussing short-term dynamics. But leaving the daily swings aside, I cannot help but think that it is difficult to get very excited about the outlook for equities over the next few quarters.

There can always be rallies from a starting point of excessive bearishness. But beyond that, the scope for a substantial, fundamentally driven rally seems small, in our view. Even if investor expectations of recession risk do not get pulled forward from the second half of 2023, the spectre of a recession on the horizon remains; it’s difficult to see it being priced out completely.

From today’s starting point, we believe a soft landing that extends the US economic cycle would be very bullish and could, indeed, deliver new all-time highs. But it’s also difficult to imagine sufficient data to significantly increase confidence in that scenario for a long time to come. It feels like the upside to rallies will probably be capped for the time being. As a result, our team’s view on equities is only modestly positive.

Recovery pricing

If we ultimately go down the recession path in the second half of 2023, as our economics team expects, then we’re still quite far away from pricing in the recovery. The point to price in the recovery and the next cycle is normally when investors have confidence on when and at what level the economy and earnings will trough. If the recession begins in the second half of 2023, then visibility on that must be much further away and too distant to even think about today.

Equities may already have played out half of the average bear market decline unusually early, but in my view it’s difficult to see the market pricing the recovery for quite some time.

 

[1] Source: Bloomberg, as at 24 May 2022.

[2] Source: LGIM analysis as at 24 May 2022.

[3] Source: LGIM analysis as at 24 May 2022.

Lars Kreckel

Global Equity Strategist

Lars is not your average German: he owns the house he lives in, has two children and drives Japanese cars (one electric). Maybe that’s also why he covers equities rather than bonds?

Lars Kreckel