The Fed has been aggressively hiking rates since March 2022, the yield curve has been inverted since last fall, and overall financial conditions have tightened dramatically. We think we’re headed towards recession; the market thinks we’re heading towards recession, everyone thinks we’re headed towards recession. The question isn’t “if, it’s “when”. Universally accepted it’ll happen in 2H23.
Three things to expect when you head towards recession:
First, the economy slows and unemployment heads higher. We’re coming off a very low 3.5% base on the unemployment rate so even a 1% jump in this rate might feel like the end of the world. Job losses have hit the tech sector so far but will broaden in the coming quarters. Look no further than Disney announcing layoffs this week as proof the trend is in place for higher unemployment.
Second, corporate earnings go down, probably in the neighborhood of -10%. That slowing has already started. We are halfway thru 1Q earnings season and earnings are softer by 3-5%. That’s’ the bad news. The good news is the market went through a major valuation re-set last year. P/E multiples on SP500 have gone from 23x to 19x already. It may not completely be in the price, but I believe much of this is already in the price of the market.
And third, a default cycle emerges in corporate credit. You can’t have a recession without a spike in the bond default rate. DB has a great chart (below) out this morning that I wanted to share. Focus on below is the big blue bars. That captures the percentage of companies that are likely to have an interest coverage ratio of <1x in the next three years (FYI – interest coverage is your cash earnings divided by your cash interest expense. Lower isn’t good.) 15% of the broad stock market suffers from this affliction today. When we preach “own quality” this is one measure of why. Bond defaults will go up and that rhymes with permanent loss. Own quality and avoid levered stocks and high yield bonds as we enter this leg of our journey. High yield credit might be an opportunity later this year but price needs to come our way, and not by a little. AVOID HY.
Source: Bloomberg Finance LP, Deutsche Bank as of April 27, 2023
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