Key Points: 

  • Our recession lead indicators are flashing red and recession is inevitable. However, it’s still too early to increase the underweight in risk assets. The 2-year bond yield hasn’t begun to price in an easing cycle yet, and this is normally the final nail in the coffin. High-yield credit spreads and jobless claims are both rising and consistent with the slowing economy. Spreads have actually tightened a little in the past few weeks, but these indicators don’t lead, and contemporaneously follow the equity market lower. Increasing the underweight at this stage would leave investors underexposed to good news such as a slowdown in the pace of Fed tightening or easing supply chain pressures.
  • Sentiment became excessively negative towards risk assets in the past few months. Equities subsequently recovered some lost ground as these fears were not realised, but this doesn’t mean a recession won’t be priced in the months ahead. The equity market has never got the recession call right, and we need to remain vigilant.
  • US reporting season is around 50% complete and, so far, good enough. Consumer sta- ples (88%) and Technology (82%) have high EPS beat ratios, while Communication Services (45%) and Energy (66%) have been disappointing. The S&P500 EPS beat ratio is currently 76%, slightly below the long-run average (78%). Energy reported a beat ratio of only 67% on EPS, but 83% on revenue suggesting analysts overestimated the sector’s ability to convert the surge in prices into EPS growth.
  • The downward pressure on margins has further to go. US margins are under pressure mainly from cost pressures at this stage. However, monetary policy works with lags and further downward pressure is likely once weaker demand emerges. Consumer discretion- ary margins are collapsing, and Technology and Industrial margins are also under pressure. Consumer staples are showing more resilience than they normally do late cycle.
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