In 2022, markets welcomed all bad news on the economy as good news hoping it signals a pause in Fed rate hikes. Going into 2023, we think a pause in the Fed rate would be a major tailwind for the economy in the face of falling inflation. But as the economy slows and creates a headwind for the economy, will bad news on the economy be bad news for the markets? 

One can argue that the bad news is already in the price.  History favors buying a dip – S&P has fallen more than 20% on 10 occasions after World War II. Buying a 20% dip led to an average 17% return over 1 year with a positive double-digit return 7 times.  

A third important factor would be peaking of the US dollar which will signal market leadership moving back from USA to Emerging Markets.

#1: Inflation has peaked – Fed will pause in H1CY23

We, at Valentis believe inflation has peaked and should see a meaningful downturn over the next few months. The one reason for a rally in commodity prices and inflation could be pent-up demand in China as the economy opens up post-Covid lockdown. But we think there are 3 reasons why inflation is headed down: 

 (a) The Ukraine-Russia war has been localized and many commodity prices are already below pre-war levels. 

(b) Supply bottlenecks post-Covid are now easing (China opening up will further help) and we are starting to see ocean freight rates come down as well as port congestion ease.

 (c)  global demand is starting to slow and this is bringing down prices of commodities.  

So what does the Fed do? With the Fed having front-loaded rate hikes, we expect them to pause in the first half of 2023 after probably another 75-100 bps further rate hikes. 

What do markets do when Fed pauses? Post the last Fed hike, markets have generally been positive. There have been 6 Fed pause cycles in the last 40 years. On an average, markets gave 4% return after 6 months and 12% return after 1-year with only 1 out of 6 returns being negative.

#2: Recession in the USA? 

The Fed has been very clear that they want to kill inflation even at the cost of leading to a slow-down in the economy. We have seen the fastest pace of Fed increase since the Volker era and the Fed rate is likely to go above 5%. The Fed is also shrinking its balance sheet at around its announced pace of US$ 95 billion per month. So is this leading to a significant slow-down in the US economy? The data is mixed so far: 

  1. The bond yield is inverted. In every recession we saw the bond yield inverting 6-18 months before the recession began. But every inversion has not necessarily led to a recession. 
  2. The ISIM index has seen a distinct slow-down in both manufacturing and services over the past few months.
  3. However, the unemployment rate, which the Fed is very focused on, is still close to historic lows. Anecdotally, however, we are starting to see many tech companies announce reduction in work force.

Overall, at Valentis, the thought is that there will be a slow-down in the world economies with a reasonable chance that we see a recession in the USA. What does a recession mean for the market?

  • An average recession in the USA lasts for 12.5 months and including the Great Depression (1929-1933), it lasts for 15 months.  
  • Typically, the markets tend to correct 6 months before the recession with average fall of -1.4% (excluding the Great Depression). The average stock market returns during the recession have been flat excluding the Great Depression and -7% including the Great Depression period. However, the average masks a wide variation in the return with the Global Financial Crisis producing the worst returns since the Great Depression.  
  • Post the recession, markets have seen a rebound with average returns aggregating 15% post the Great Depression period. 

#3: Dollar peaking will help Emerging Markets 

Since 2008 the US$ has been on a tear and has appreciated 45% (DXY index). We think the US$ may be peaking led by 2 factors (a) rate increases in USA may be coming to an end and (b) recessionary conditions in USA may put pressure on the US$.

What are the implications of a weak USD? Since 2008, developed markets are up 278% sharply outperforming emerging markets which are up a more modest 69%. We think the US stock market outperformance is behind us and expect emerging markets to (a) grow much faster than USA and (b) EM equities to outperform US and other developed market equities.