Why are stock markets so happy all of a sudden? It may be because a recession is looming.
The possibility of a perfect, bite-sized recession offers one of the more plausible – if rather odd – rationales for why Canadian and American stocks have made nice gains over the past month.
An optimist can now tell a just-so story that begins by assuming a mild, quick downturn in 2023. The slowing economy drives unemployment higher and tightens corporate budgets. Inflation falls in response. This, in turn, allows central banks to start slashing interest rates as early as the middle of next year, putting stocks in good position to make further gains.
If you trust in this sunny tale, stocks look to be at least somewhat attractive right now. But is this story actually realistic? Let’s look at the evidence.
Everyone’s favourite recession indicator, the yield curve, is now sending out troubling signals in both Canada and the United States. It measures the yield on government bonds of various maturities. Most of the time, longer-term bonds – ones that mature in 10 years or more – yield more than shorter-term ones maturing in, say, two years.
When that pattern reverses, and shorter-term bonds start paying higher yields than their longer-term counterparts, the curve is said to be inverted. This signals growing caution about the short-term outlook and has historically been an outstandingly accurate indicator of recessions ahead in the U.S.
The deep inversion on display in today’s yield curve suggests that a recession is coming, probably in early to mid-2023. The catch is that the curve doesn’t offer any clues about how deep or long-lasting the recession will be.
This is where things get murky. The past two-and-a-half years have been a wild ride. They have left us with an odd mix of positives and negatives.
On the positive side, unemployment has rarely been lower in both Canada and the U.S. Oil prices have slid back from their highs after the Russian invasion of Ukraine and now hover only slightly above their pre-incursion levels.
Meanwhile, global supply chains are unclogging rapidly, according to the Federal Reserve Bank of New York. Inflation in durable goods (such as refrigerators, sofas and the like) has skidded dramatically lower in recent months, showing how quickly runaway prices can be tamed under the right conditions.
All of this is encouraging. It suggests any recession ahead could be as mild as investors are hoping.
On the other hand, the negatives can’t be overlooked. While durable-goods inflation may be rapidly subsiding, inflation as a whole is still running around 7 per cent a year in both Canada and the U.S., vastly above policy makers’ 2-per-cent targets.
Both the Bank of Canada and the U.S. Federal Reserve have made it clear that interest rates will remain high until inflation is whipped. Some observers, such as Roberto Perli, head of global policy at investment bank Piper Sandler, think in practice that will mean leaving interest rates at lofty levels throughout all of 2023.
As things now stand, higher interest rates are crushing housing markets in both countries and raising companies’ borrowing costs. Higher rates are also making the sure payoffs from bonds and guaranteed investment certificates, or GICs, look like an enticing alternative to the more dubious payoffs from holding stocks.
This does not bode well for share prices over the next few months. Analysts at UBS see stocks doing nothing until the middle of next year. Their counterparts at Morgan Stanley predict U.S. stocks will tumble in the first quarter of next year and end 2023 pretty much where they are now.
The market rally won’t last, David Rosenberg of Rosenberg Research warned this week: “We expect the market to ultimately make lower lows” as corporate earnings deteriorate from their pandemic highs, he wrote.
If nothing else, this torrent of analyst skepticism should make investors think twice before betting too much on the current rally. In the U.S., bear markets often end when stocks are trading at around 13 to 14 times the earnings forecast for the year ahead. Right now, they are trading for nearly 18 times earnings – and many analysts think those projected earnings are in line to be cut.
Value hunters can make a more enticing case for Canadian or European stocks, both of which are trading at only about 12 times forward earnings. The catch there is that their immediate outlook hinges on whether the global economy can stage a strong recovery. That doesn’t seem imminent, according to recent dour outlooks from the International Monetary Fund and the Organization for Economic Co-operation and Development.
Maybe, just maybe, it’s time to practice some strategic patience. Sure, falling inflation in durable goods and improving supply chains suggest the world is slowly grinding its way back to normality. But a mild recession, if not worse, still seems to lie in our way.
Until we find how just deep and long-lasting the downturn will be, investors may want to wait for a better buying opportunity.
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