Recession odds fall, a bit

Good morning. Thanks for the heap of responses to yesterday’s letter. Readers’ views, as you will see below, fit pretty well with the Federal Reserve’s latest meeting minutes, released on Wednesday. Fed staff economists are forecasting “a mild recession starting later this year”, but with a whopper of a caveat. Narrowly avoiding a recession, Fed economists think, is “almost as likely as the mild-recession baseline”. A resigned shrug, in other words, delivered with a side order of optimism. Email us: [email protected] and [email protected]. 

Readers’ views of the year to come

Yesterday we asked readers for views about the economy 12 months from today, by assigning a probability distribution to this matrix:

This was a slightly updated version of a matrix we added a year ago (back then, the X-axis queried the future fed funds rate, not core inflation, but the general thrust was the same). And while opinions are spread quite evenly over the four outcomes, indicating uncertainty, it is notable that over the intervening year, Unhedged’s readers have become less concerned about recession. They put the chances of one at 55 per cent, against our 60 per cent; a year ago we’d both agreed that the odds of a recession were two in three. As for high inflation, readers trimmed their odds from 45 per cent to 40 per cent:

Readers have also tempered their fears about the worst-case scenario — stagflation. Readers cut by 10 percentage points the chance of entrenched inflation and a recession in the next 12 months, with opinion significantly more concentrated than last year (ie, there was a lower standard deviation among responses). With inflation’s peak in the rear-view, that makes sense, too.

In all, then, respondents have a slightly more benign view of things than they did a year ago (40 came back with a complete set of probabilities that added up to 100 per cent; many others wrote to stump for one outcome or another as most likely). This is not surprising, in that inflation has eased recently while growth has hung in there.

Our readers are a bit more optimistic than we are. We defer to their wisdom, and hope that they are right. 

If you believe in a soft landing, buy (some) small-caps

Unhedged has never put high odds on a soft landing, for the simple reason that monetary policy is not surgical. It lowers inflation by hurting growth, and that is a very easy thing to overdo. We still believe that. But as more resilient economic data rolls in, we have to admit that the probability of a soft landing is rising.

One vision of soft landing, advanced most notably by Fed governor Christopher Waller, revolves around the Beveridge curve, an economic model tying the job vacancy rate to unemployment. The pandemic transformed the Beveridge curve; as Help Wanted signs went up across the US, the vacancy rate soared. The yellow line below shows the Beveridge curve immediately after the pandemic struck, while the blue line shows the two decades before Covid. Notice that for any given level of unemployment, pandemic-era vacancy rates along the yellow line are higher than the blue baseline (chart from Morgan Stanley):

Waller’s soft-landing idea, illustrated with the green triangles above, is that vacancies might fall with only a modest increase in unemployment. Such a gentle reversion to pre-Covid norms would defy the historical record, but it could happen. The US has a structural labour shortage, and if employers keep gobbling up workers, you can’t have a recession. As Jay Powell put it at his May press conference: “It’s possible that this time is really different. And the reason is, there’s just so much excess demand, really, in the labour market.”

To repeat, we are sceptical. Excess labour demand means steady wage growth, which puts a floor under consumption and therefore inflation. Stubborn inflation will egg on the Fed to raise rates higher, bringing down inflation by engineering a recession. But so far, sceptics like us are stuck talking about a scary future, rather than the scary present. The Beveridge curve has moved in the direction of the soft-landing believers. 

And investors seem newly eager to buy on good economic news. Twice last week, resilient economic data pushed up stocks and tightened investment grade credit spreads. This, points out Yuri Seliger of Bank of America, is unlike the string of strong economic data in February, which saw wider (ie, bearish) IG spreads and falling stocks. The market sees a less painful growth/inflation trade-off than it once did. 

So for investors on the hunt for a trade, here’s one: small-caps. The case for them starts with valuations. The S&P 500 is expensive no matter how you cut it. But not the humble Russell 2000. Valuations for this small-cap index are better assessed by price/book ratio than standard forward p/e, Goldman Sachs analysts argue in a recent note, pointing out that smaller companies may not be profitable or have reliable analyst earnings forecasts. On a p/b basis, then, the Russell looks reasonably priced:

Next, consider the biggest risk to small-caps: the business cycle. Compared to large-caps, small-caps’ weaker balance sheets and more volatile revenues expose them to cyclical vicissitudes. Traditionally, that has meant small-caps sag late into a cycle, when investors flee to quality, and then rebound once recession draws to an end. The chart below shows the ratio between the S&P 500 and Russell 2000, where a rising line means small-cap outperformance. Early cycle is when you want to own the Russell:

Small-caps currently labour under a discount driven by recession anxiety. The bet is that if that doesn’t happen, and it turns out we are not late in the cycle after all, the discount should dissipate.

Even in a soft landing, there are risks to small-caps. One is that rates stay higher for longer. No recession means no reason to cut rates, and nearly a third of Russell 2000 debt is floating rate (versus 6 per cent for the S&P), notes Goldman. Higher debt costs would pinch small-caps’ thinner margins, denting performance. Another risk is sector composition. Todd Sohn of Strategas points out that “boom or bust biotech” is also over-represented in the Russell, and looks mired in a bust phase. Also, investors might want to think carefully before owning small-cap banks right now, and they make up 7 per cent of the Russell but only 3 per cent of the S&P.

Both of these problems could be ameliorated by not buying the whole index — say by picking a basket of low-leverage stocks, avoiding biotech and banks. Sohn suggests tilting towards small-cap industrials, the largest sector in the Russell and one chiefly exposed to growth. (Ethan Wu)

One good read

From the Eurasian department of mutual incomprehension.

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