Weekly Market Analysis: Who Wins if the Fed Drives a Recession?

If the Fed ignores positive inflation developments and continues on its rapid tightening path, CIO believes that only a decisive weakening in employment will cause it to change course. Given the data, one can see that the Fed will have to sustain its higher rates for longer to intentionally diminish aggregate demand and point employment downwards. Forward-looking financial conditions – measured with both bank lending standards and US equities – already suggest a moderate contraction in employment will come in the year ahead. CIO’s forecast update last month incorporated a sub-1% 2023 GDP gain for the US, with a likely period of economic contraction during the first half 2023. CIO expects global growth next year to be the weakest of the past 40 years apart from the COVID shock and 2009.

This is why policy impatience is a bigger risk than slowing demand. The next time the Fed eases, it may not be a cure for a cyclical contraction. Rather, it is more likely to signal that it “succeeded” in causing a major deterioration in employment and must react to it.

Given the roughly 50% odds of full-blown recession next year, CIO has adjusted portfolios to reflect these concerns. In August – ahead of Fed Chairman Jerome Powell’s speech at Jackson Hole – CIO reduced its broad exposure to energy and materials, which have yet to price in a meaningful drop in profits. CIO has retained defensive assets likely to exhibit more resilient underlying earnings and shareholder payouts in a recession. 

The range of sector-level profit declines associated with recessions varies from 1990 to the present. Outside of financials and retailers, few sectors have even begun to report falling earnings through the first half of 2022. While CIO doesn’t expect a profits contraction like the severe 2008/09 period, even shallow recessions consistently lead to double-digit EPS declines in more economically sensitive industries.

It’s possible CIO is being too conservative; a profits recession can be avoided if the Fed looks more practically at future inflation trends, rather than lagging indicators in setting policy. But a more likely explanation is that corporate executives reflect mostly on current business trends rather than the future impact of central bank policy tightening. Indeed, continued profits strength in Q2 confirms there was no early 2022 recession, in spite of two quarters of negative real GDP growth.

At the sector level, energy and materials stand out as most vulnerable to a correction as cooling global demand dents commodity prices. Slowing Chinese economic growth, a continued reduction in new orders out of the US and potential production cuts ahead of European winter could all have the effect of reducing energy, metals and chemicals demand into year-end. The sectors likely to see much less variability in profits include health care and staples. Even though these sectors have already outperformed the market thus far in 2022 by 5% and 11% respectively, it’s difficult to justify shifting portfolios to a more cyclical allocation before profits have even begun to decline for most of these segments.

Earnings will become the key focus for equity investors for the remainder of 2022. CIO believes both trailing and consensus estimates are too high for the next 4-6 quarters. The market still looks somewhat expensive at over 20x EPS. In particular, while energy seems cheap relative to the last 12 months’ earnings, the sector’s outlook is less rosy if a global recession drives oil prices meaningfully lower.                

Note: Past performance is no guarantee of future results. Real results may vary.