Analysis | The Slowdown Story Comes With an Ugly Ending for Stocks

For asset allocators, the prospect of lower growth and falling rates would mean that it makes sense to buy bonds. Stocks still don’t look terribly attractive. And the way investors are embracing that narrative grows clear from the sharp decline in bond yields ahead of the Fourth of July holiday.

The latest reason for pessimism about the economy comes from the June ISM supply manager surveys for manufacturing. They were unambiguously disappointing. Over time, the surveys have been good leading economic indicators, scaled so that a number below 50 means a contraction, while numbers above it signal growth. On that basis, US manufacturing is declining fast, but is still not yet into recessionary territory:

The detail of the report is more concerning. The ISM includes indexes for both new orders and inventories, and this is a good way to track the “re-stocking” cycle. When new orders exceed inventories, that suggests growth ahead to meet demand. When new orders are below inventories, however, things look much more contractionary. This signal grows even more discomfiting if the new orders number is below the recessionary cutoff of 50. All times when these conditions have been met since 1990 are circled in the chart below:

There have been a couple of false alarms, in early 2012 and in 1995, so this isn’t foolproof. But the sharp decline in new orders while inventories remain robust is unambiguously bad news. The odds on a recession are rising.

That feeds into a narrative that had already taken root among asset allocators. The latest survey of international money managers by Absolute Research Ltd. asks respondents to estimate the probability of various outcomes and shows that “TINA,” the idea that There Is No Alternative to stocks, is more or less at an end. Stocks usually outperform bonds over a given 12-month period; but now, only 53% of money managers believe that they will do so over the next year. That is the lowest figure since the survey started in 2015:

That’s hard to square with an enduring belief in stagflation, in which bonds can be expected to take a pummeling. The loss of enthusiasm for equities instead reflects a belief that bond yields have risen about as far as they need to. Also, the strangely symbiotic relationship between the two asset classes affects bullishness over stocks. Historically low bond yields have supported stocks for a while; now that bonds have taken a fall, the risk is that stocks will be next in line.

The ebb and flow of belief in a recession shows up clearly in the relative performance of stocks and bonds this year (proxied, as I usually do, by the SPY and TLT exchange-traded funds that track the S&P 500 and Bloomberg’s index of long-dated Treasuries). This has been a historically awful year for bonds; yet on July 1, as Wall Street prepared for Independence Day, bonds at one point had outperformed stocks for the year:

The chart attests to the volatility of sentiment over inflation, and over the likely effect on the economy. After the invasion of Ukraine, stocks dipped badly relative to bonds as a recession seemed more likely. Stocks then enjoyed strong outperformance as the inflation figures worsened; and now, with worrying numbers on growth, stocks have fallen back again. Inflation fears are receding, but only because of confidence that the economic slowdown will be so drastic that it will extinguish pricing pressure.

Within the stock market, the declining fear of inflation is also evident. Societe Generale SA keeps an index of the stocks in the MSCI World index that are most closely correlated with inflation — in other words, they tend to do better when inflation is high. These inflation proxies had a terrible time of it in the years leading up to the pandemic, and they’ve been rallying ever since. Then in the last couple of weeks, they endured a sharp reversal:

The narrative has unmistakably changed, and growth fears may now even be more important than worries about inflation. Rather than keeping a lookout for signs of moderating inflation, attention now will be hogged by any evidence that the economy is slowing down. 

For those who still find the stagflation narrative more realistic, the twist in the tale does create an opportunity. Selling bonds or buying inflation proxies can now be done for much better value than a few weeks ago. 

Return to the Bottom Line

The macroeconomy matters to the stock market, but chiefly for the way it affects the two key variables that drive share prices: the earnings that a company makes, and the multiple that people are prepared to pay for those earnings. Multiples are driven by many things, but we can agree that higher bond yields and fears of a recession are not good for them. Investors will be less inclined to pay more for a future earnings stream in such circumstances. By any sensible yardstick, multiples last year reached infeasibly high levels. 

That means investors started 2022 braced for declines in multiples, and that’s exactly what they’ve had. However, the Absolute Strategy survey shows that even now, most big money managers are still working on the assumption of further declines over the next 12 months.

Nobody expects a rebound then. Instead, the critical variable will be earnings themselves. Investors are very, very bearish about them, as the following chart from the Absolute Strategy survey demonstrates. After years of widespread confidence that earnings would keep rising, a clear majority of fund managers are now hunkered down and waiting for a decline:

It’s easy enough to see why. Rates are going up, taking borrowing costs with them, while everyone seems to assume that a recession is coming. That is likely to translate into declining earnings.

But the top-down logic so clear to asset allocators doesn’t seem so obvious to the brokers who compile the earnings estimates that are then compounded by Bloomberg and other data services. Expectations for both the quarter just finished and the one starting are higher now than they were at the beginning of the year — quite significantly so for the third quarter.

Energy stocks, which benefit from higher oil prices, do cloud the picture. Exclude them, and earnings expectations for the rest of the stock market have fallen over the last six months, but not to the kind of extent that would be implied by the macro gloom. The following chart is from Andrew Lapthorne, chief quantitative strategist at Societe Generale:

The MSCI World index of stocks in the developed world tends to be strongly correlated to profits growth, with a fall generally presaging an imminent tumble in profits. That certainly seems to imply that the market is braced for lower profits, even if the analysts in brokers’ research departments don’t say so:

The mathematics of the situation are merciless. Either profits are about to fall or, if they don’t, central banks will have to keep raising rates until they do. That would continue to put pressure on multiples. To quote Lapthorne:

The problem facing equity investors is if a slowdown/recession is indeed on the way, then today’s earnings forecasts are way too optimistic, and there have only been a limited number of downgrades so far (currently, globally there are as many upgrades as there are downgrades). This surely must change during the upcoming reporting season; otherwise, we assume, that both demand and price increases are holding up and the central banks would need to continue hiking.

If the new story of imminent slowdown and a limited monetary tightening campaign turns out to be true, then the narrative on earnings will have to change. That positivity about earnings is what is keeping stocks from selling off far more. Asset allocators plainly don’t share that upbeat view  and believe stocks will lag bonds. The next couple of weeks will bring critical macro data on inflation and employment; but immediately after that the earnings numbers will start to flow. It might not be pretty. 

The Fourth of July weekend has been fun, as it usually is, despite all the indications of discontent in the US. In Boston, where the War of Independence means a lot, I was lucky enough to see the Red Sox actually win by four on the Fourth. Quite a party. Earlier in the weekend, however, I went to the Museum of Fine Art for the first time in decades. It’s a great museum, radically redesigned since I was last there. The centerpiece of the museum at present is Turner’s Modern World, a quite extraordinary exhibition of the 19th century painter’s work, featuring many pieces that normally stay in storage in London’s Tate Britain. There was far more to him than twee seascapes. Turner was also a brilliant chronicler of the Industrial Revolution and its effect on the world, and a searing political critic.

Try looking at Slave Ship, which is part of the MFA’s permanent collection. There’s a ship in trouble, a stormy sea and a dramatic sky. Then as you look closer you see hands reaching from the sea in the foreground, black manacles floating, and birds and fish homing in to feed on the human carrion. It’s based on the true story of British slavers’ practice of taking…