Summertime In The 70s

The good news is, it’s difficult to imagine the back half of 2022 being worse than the first six months.

Stocks stumbled Thursday in a drab session befitting of the worst first half for US shares in decades. Already somber sentiment took another hit from a lackluster read on personal spending, which bolstered the recession narrative at the expense of policymakers’ increasingly far-fetched pretensions to soft landing glory.

“US consumer spending has been revised sharply lower through the first four months of the year, and with May now reporting an outright contraction, it’s clear that the trajectory of the US economy is not looking good,” ING’s James Knightley said. “Further interest rate rises and an ongoing squeeze on spending power mean that growth forecasts are likely to be cut with recession risks rising.”

At this point, it’s entirely possible that by the time Wall Street gets around to adopting a recession as the base case, the BEA will be on the brink of confirming a second consecutive quarterly contraction.

The outlook is bleak, even if the odds of a second half as bad as the first for stocks are low by virtue of just how bad H1 was. The S&P’s near 21% decline ranked fourth going back to the Great Depression (figure below).

There’s no utility (at all) in attempting to interrogate the past for answers about the future. In addition to a desperately indeterminate macro backdrop, the odds of successfully predicting positive returns in the back half of a year based purely on whether the first half saw losses are about fifty-fifty.

You can find plenty of strategists willing to suggest the rates shock is priced in considering the scope of valuation contraction in US shares. The problem now is estimating the downside from a recession and the attendant hit to corporate earnings.

To many observers, bottom-up consensus is hopelessly behind the curve when it comes to cutting estimates. In aggregate, profit and margin forecasts reflect no recession risk whatsoever, despite the distinct possibility that the economy is already in a downturn. The figure on the left (below) shows that after drifting ever higher, profit forecasts have finally stopped rising for this year and next, but haven’t even begun to recede.

The figure on the right (above) shows how bad things can get for earnings during the depths of recessions.

It’s tempting to offer the boilerplate line about “much depending on the Fed.” That’s certainly true to the extent the Committee is effectively condemned to hike the economy “off a cliff” (as Elizabeth Warren put it) in order to guard against an un-anchoring of longer-term inflation expectations. But what we’ll actually witness over the next several months are the lagged effects of the tightening delivered since March.

Arguably, the Fed has already “broken something,” as the saying goes. Falling breakevens and lower terminal rate pricing could be construed as faith that monetary policy will succeed in curbing inflation without having to venture too far into restrictive territory. They could also be construed as a lack of faith in the Fed’s capacity to curb inflation without causing a recession that necessitates (another) hard pivot. STIRs argue for the latter interpretation.

Whatever the case, a shallow recession certainly won’t deter the next 125bps worth of tightening. It’s what comes after September that’s up for debate. “A recession wouldn’t prevent more rate hikes, even with GDPNow revised to -1.0% for Q2,” BMO’s Ben Jeffery and Ian Lyngen said Thursday. “This will leave June’s data to boost the outlook for the second quarter, and as the new information is gradually revealed the risk of a technical recession has risen.”

If nothing else, the Fed would have a lot of explaining to do in the event tomorrow’s recession happens today. Although analysts and economists would do their best to explain away a negative Q2 GDP print just like they explained away Q1’s contraction, the public isn’t very receptive to nuance. And thanks in part to the financial media’s penchant for monetizing the clicks recession stories generate, voter interest is piqued (figure below).

In addition to messaging “no recession,” the Fed has been adamant about doing what’s necessary to keep inflation expectations in check. Those two outcomes (the absence of a downturn and winning the inflation war) aren’t necessarily compatible. But because it’s not politically feasible to tell the public the unvarnished truth (i.e., that part and parcel of the plan is engineering a higher unemployment rate and, if necessary, a recession), everyday Americans aren’t apprised of the extent to which economic sacrifice is required to rescue the country from an inflationary spiral.

“Policymakers have begun to more clearly note the risks of unanchored inflation expectations, and what would likely be a more severe tightening response,” Nomura’s Charlie McElligott said. “The growing emphasis on long-term inflation expectations adds a new dimension to the Fed’s reaction function which escalates the risk of an ‘accident.'”

Writing Thursday, SocGen’s Subadra Rajappa described central bank messaging as an attempt to convey the notion that “failing to restore price stability is currently a bigger risk than generating recession.” “The market has taken note and is repricing down inflation breakevens and terminal rates,” she said. “Amid growing recession fears, bond yields have become increasingly sensitive to falling equities. It has the feeling of summertime.”