We talk about “cycle investing” all the time – that’s the time-tested belief that over time markets are driven by monetary policy and the cost and availability of credit. It’s tough to have a growing economy and improving earnings when lending gets tight and the demand for credit falls. History says so. In a “typical cycle” (like the 9 cycles prior to the current cycle) the story goes like this:
- Phase 1: Economic recession…The economy gets warm/hot and the Fed starts to hike. Equity markets generally ignore this and enjoy an extended period of euphoria. But economic data eventually starts to weaken, and inflation falls and the labor markets soften.
- Phase 2: Earnings recession… A weakening economy translates into weaker/lower earnings. An earnings recession starts to develop, usually takes 3-4 quarters to happen but it eventually does happen.
- Phase 3: Market recession… A weak economy + lower earnings results in a repricing of risk assets. Lower multiples, lower valuations, lower prices. Lots of equity market volatility.
- Phase 4: The Fed stops hiking rates and eventually reverses policy and cuts rates…A new cycle is born.
As we have said many times, the current cycle isn’t like any other cycle. When you get hit by a global pandemic and are forced to print trillions in stimulus of all shapes and sizes sometimes the ol’ playbook changes. The current cycle looks like this:
Phase 1: Market recession... In late 2021/first half of 2022 the Fed got way too far behind with regards to inflation and a policy mismatch ensued. Lots of equity market volatility.
Phase 2: Earnings recession… Revenues have been fine, but cost pressures have resulted in modestly lower earnings for 3 quarters now. We think the current quarter will market the cycle low in earnings.
Phase 3: Economic recession… It’s consensus and it’s coming. The Fed has had both feet on the brake for 18mo now. Fastest, most aggressive rate hiking cycle in history, the yield curve has been inverted for almost a year now, and the Fed has been aggressively shrinking their own balance sheet (“quantitative tightening”). What’s next is the most telegraphed recession in history. The chart below confirms such. Commercial and industrial loan demand from businesses is falling and falling fast. Financial conditions have gotten very tight and small business owners are looking ahead to the next few quarters and expecting a slowdown. They don’t want a new loan that looks like expensive money heading into a recession.
Phase 4: Fed cuts coming to a theatre near you early 2024.
The good news is that the Fed sees this data too and Fed chair Powell will likely use their annual late August Jackson Hole summit as the time to announce to all that rate hikes “might” be over. It won’t be a pronouncement that they are over, “might” will be the most we get but the market will like/love “might”.
Staying away from high yield bonds, staying away from commercial real estate, and starting to embrace the idea that the front end of the UST yield curve looks like good value. If the past year was about an inverted yield curve, the next twelve months will likely be about a sharp drop on the front end and a return to beloved yield curve steepness.
Source: Bloomberg LP and Federal Reserve as of July 31, 2023
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