The good news is that equity markets have suffered two consecutive years of losses only five times in the past one hundred years. But the bad news is that all the preconditions for that to occur seem to be in place.
Specifically, markets have run hard beforehand, while valuations remain high. Interest rates have gone up, and the recession for earnings and the economy have followed.
A further warning sign is the inversion of the yield curve at the point that is most favoured by Federal Reserve chairman Jerome Powell: the three-month yield versus the 10-year rate.
That curve has only been inverted to the same extent in 1929, 1973 to 1974, and 1979 to 1980, which were not good times to own risk assets.
“The pace, scale and breadth of monetary tightening that we’ve seen in the last 12 months is unlike anything we’ve seen since the 1980s, and it would be a complete miracle if we escaped recession,” he said.
Powell, he says, won’t respond to the first indications that inflation is easing. It will instead take a sharp rise in unemployment or a financial crisis of sorts to force an interest rate retreat. And for that reason, he argues, it’s a dangerous strategy to wait it out in equities.
Harnett’s conservative forecast is for the S&P 500 to fall from its current level of about 4000 to 3200. That’s based on a 10 per cent decline in earnings from 220 points to 200 points and the historic average multiple of 16 times applied to those earnings.
If earnings fall by 20 per cent – as they typically do in a recession – the market is currently trading on 23 times those forward earnings (or would decline by 28 per cent on a 16 times multiple).
Cautious on reaching for yield
European stocks look even more precarious at 19 times recessionary earnings versus the long-term average of 14 times.
Although ASR likes bonds on relative value, they’re cautious on reaching for yield in the credit market. That’s because a seemingly reliable forward indicator of corporate defaults is flashing red.
The Fed’s senior loan officer’s survey has shown that banks are tightening lending standards while demand is dropping off. The current levels imply a rise in corporate defaults to between 8 per cent and 10 per cent, and if that eventuates, credit spreads are insufficient compensation.
A default cycle of that magnitude would inflict losses on debt investors but also strain the financial system.
It could be a factor that forces the Federal Reserve to capitulate and cut interest rates.
But Harnett says a more likely catalyst is housing, which is turning into a global risk. ASR’s own monthly global house price index has fallen almost 9 per cent on a three-month annualised rate.
This, he says, is on par with the house price declines of the global financial crisis, while the pace of European house price declines is actually worse.
In the so-called late cycle economies – Australia, Canada, Norway, Sweden and New Zealand – the aggregate declines are also worse than during the global financial crisis.
His weekend reading included the Financial Review reports about banks writing loans below their cost of capital.
“The last time I saw anybody trying to do that was Japanese banks in the early 1990s and that didn’t end well.”