Regardless of how far it reaches, there is a historical constant: that markets recover when the economy is in a downturn.
There should not be many precedents for a recession as widely discounted as the one we expect in the coming months. Although we continue to see some strength in corporate earnings, or in lagging macroeconomic data, the levels of confidence indices or leading indicators paint a clear recessionary scenario on the horizon.
Beyond macroeconomic data, financial markets (as always) have been anticipating and pricing in the recession that seems increasingly inevitable for months. Depending on the asset we look at, the degree of discounting varies; for example, the slope of the US curve between the 2-year bond and the 10-year maturity reversed last July, even though the model used by the Fed (the slope between the 3-month and the 10-year) still gives little chance of recession. In the case of equities, the anticipated recession probability has reached 85% at the worst times this year. If we look at credit spreads in corporate bonds, both Investment Grade and High Yield, we are already at levels that correspond to recessionary scenarios.
Therefore, from the point of view of the financial markets, the recession has been here for some time now. This, however, need not be a particularly negative circumstance for the investor. Regardless of the extent of this recession, there is a historical pattern that has been repeated in virtually every previous recession, and that is that markets recover when the economy is in the midst of an economic downturn.
It is impossible to establish the extent of such a future recession. Historical precedents may provide a reference but, unfortunately, the economy does not work in such a linear fashion and even more so when there are too many moving parts and exogenous factors (such as the war in Ukraine) that can completely change the scenario in one direction or another.
Perhaps it is more useful not to try to predict the extent and duration of the recession but to look at the level reached by financial assets and consider whether they represent an opportunity or not.
In the case of sovereign debt, the pickup in inflation has altered all the curves and pushed yields upwards. The question here is whether inflation will remain structurally at these levels or, on the contrary, we will gradually see a normalization towards the central banks' target. If this is the case, and we assume that inflation will tend towards 2% in the long term, investments in government bonds at positive real rates are now possible. Something that seemed an entelechy a few months ago.
In the case of corporate bonds, yields have moved sharply higher and spreads are already identified with a recessionary scenario and debt defaults are making their appearance. Here the opportunity is also very clear; we are at levels where the fixed income investor has always made money on a 12-month basis. It is true that the inflation environment may invalidate this assumption, but an investment at a slightly longer term than those twelve months and with the cushion of current yields, offers a particularly interesting window for the bondholder considering entering at these levels.
Equities have not escaped this adjustment in expectations. Over the past few months we have seen declines that are rarely associated with high quality companies. The rebound in rates has led to a readjustment in valuations and has taken companies that traditionally trade at high multiples to levels that correspond to much more mediocre businesses. As with debt, if we consider certain factors as short-term (such as the current upturn in inflation) in a long-term investment (as by definition equities are) the market is offering us an excellent entry point for the next few years.
In our opinion, a good investor has to be aware of his limitations and capabilities. Our main limitation is the impossibility of predicting the future. Our ability is the possibility of making a rational analysis of our investments, identifying the quality and potential of these and accompanying it all with sufficient patience so that the volatility that we will continue to see in the market does not prevent us from taking advantage of the opportunities that it will offer us in the coming months.
David Ardura is Chief Investment Officer of Finaccess Value AV.