Stocks rose strongly in July driven by weak sentiment, low expectations for company earnings which key companies exceeded, and lower interest rates.
The problem we have with this rally is that inflation, the underlying cause of the market’s difficulties this year, has not gone away. If anything, inflation pressures have broadened in recent months.
As Bill Dudley, the former president of the Federal Reserve Bank of New York, argues: “Inflation is too high, the labor market is too tight and the Fed must respond — most likely by pushing the economy into an actual recession.”
However, this recession will be a late 2022/2023 story. Until economic data deteriorates further, markets can speculate that the worst has been avoided or that, even if there is going to be a recession, it is already in the price.
We have difficulty accepting this last statement, though. First, the outlook for company earnings continues to deteriorate.
At the same time, following the strong rally in July, the $SPX500 at 4130 incorporates a “risk premium” of less than 300 basis points. The historical average is 350 basis points, and in recessions, good entry points have come when the risk premium has exceeded 450 basis points.
In Bank of America’s view, recession risks mean that the $SPX500 should be valued at 17.4x earnings. This could equate to a fair value for the index of between 3250 (Bank of America’s pessimistic scenario) and 4300 (if analyst consensus estimates are correct).
We believe that the inflation problem is not solved and that as a result, the Federal Reserve will eventually have to increase interest rates more than the market expects, which will lead to a recession. At the same time, we find this is not being priced in by the market. For this reason, we continue to hold a defensive posture. The opportunity to turn more constructive should arrive in mid-2023, when we expect leading economic indicators to bottom.
The portfolio was moved back to a defensive posture because of the worsening European natural gas situation. This meant that we missed last week’s rally. However, we are not interested in chasing the market from its current levels.