The recession session II | Financial Times
An internal staff memo from the desk of Greg Peters, co-chief investment officer of the $890bn asset manager PGIM Fixed Income, reaches our inbox. It makes some timely points so we’re sharing the highlights.
Peters has been around the block and knows his stuff. Despite being known internally for somewhat jazzy jackets, he has helped manage some of PGIM’s biggest strategies since joining in 2014 and before that led Morgan Stanley’s fixed income research.
It’s fair to say that his mood doesn’t currently match the brightness of his blazers. Here’s the main message of the memo, with our emphasis.
I want to take this moment to plainly and clearly reiterate my thoughts on the market and risk opportunities. I continue to assert and thus wish to restate that I believe it is entirely too early to dip your toe into the risk waters. The simple fact is that valuations are decidedly average and the tightening into a recession game hasn’t even yet begun in earnest. The persistent inflation backdrop increases my confidence in a central bank induced recession. Frankly, I don’t see another way out.
There’s some rubbernecking around crypto “getting smoked” and how it could escalate into a “full fledged meltdown” for the space, as well as a prediction that sterling is going to nosedive because “the unsteady BOE, fraught politics and Brexit are rearing their individual and collective ugly heads”.
But the central message of Peters’ memo is on his view that central banks globally are willing to sacrifice economic growth to combat inflationary pressures. And even setting aside how fiercely (or not) central banks will react to inflation, the economic impact of price rises is starting to become a major worry.
Walmart’s woeful results on Tuesday provided one of the strongest hints yet that some companies are struggling to pass cost pressures on to consumers. That raises broader worries about both corporate profit margins and the health of American spenders — two pretty important pillars of financial market returns in recent years.
Walmart’s share puke — now down 18 per cent over the past two sessions — has naturally hogged headlines. But on Wednesday, Target also warned that rising costs were eating into profits, hammering home that this is potentially a broader problem. The news sent its shares down nearly 25 per cent, while US consumer staples stocks, supposedly one of the steadiest, most defensive corners of markets, went down a whopping 6.4 per cent.
That dragged the S&P 500 down another 4 per cent on Wednesday to take its decline to 17.7 per cent this year. The Nasdaq slumped over 5 per cent to extend its 2022 loss to almost 27 per cent.
The breadth of the sell-off reeks of recession fear, triggered by consumer-hurting inflation. This has morphed from a spec-tech wreck, to a broad tech rout, and now to an unnervingly broad market decline.
Here’s more from Peters’ memo, with FTAV’s emphasis:
In my mind, CBs have worked too hard for too long to gain inflation fighter status that they are not going to casually throw away that hard earned credibility currency. I continue to look at the early 1980s as a guide where the Fed cranked up interest rates by 10% percentage points; killed the economy which prompted inflation to fall, which in turn allowed for a multiple decade backdrop of low inflation and a reasonably prosperous economy. Perhaps, the Fed wont hit it as hard as the early 1980s given the different secular factors that they face in the years and decade ahead — but they are still going to pump the economic brakes enough to turn growth negative. In my simple mind, it is an inevitable outcome and nothing more than the uncomfortable math of monetary policy.
So yes, I have a very high probability of a recession over the next 12-24 months.
However, Peters reckons implications for markets is a bit more complex. Stocks have sold off and corporate bond spreads widened significantly, making valuations a bit less wild. But Peters still doesn’t think they are nearly compelling enough yet to start dip-buying, given the risks of recessions.
I am very sure that if the economy hits a recession, spreads will widen. Actually, that recession/spread relationship might be the only universal truth that I can accept as true. Consequently, given that we are only at the average in spreads AND I think recession risk is elevated, I don’t see a rational argument to add nonsystematic spread risk to the portfolios.
. . . The next months and quarters are highly likely to be volatile with violent moves in spreads both wider and tighter. Unless spreads blow out quickly over the near term, I would look to use the volatility to reduce risk in spread tightening (and thus better liquidity conditions) and not buy the dip. Buy the dip is a failed formula with CBs fighting inflation as a backdrop.
Only one thing would make Peters change his mind, and that is a clear sign that inflation has peaked, which would encourage central banks to back off.
This would reduce the risk of a policy mistake and/or a CB led recession. I know this sounds overly simplistic, but inflation is what matters most and driving central banks, politics and consumer psyche. All said, I believe that duration and interest rates are going to be a much cleaner play around this central bank inflation fighting into a recession narrative. At some point, although not yet as I still see another 25bp or so in 10yr yields, the rate market is going to be the first to react as I expect to see duration rally (both front-end and the belly) well before spreads. You got a preview sense of that yesterday, and past few days, but I don’t think it will hold with the Fed continuing to move thus continuing to unhinge the belly.
That said, FTAV recalls Paul Samuelson’s old 1966 quip that the stock market had predicted nine of the past five recessions. Is this just another classic markets freakout that will pass?
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