In this post, we cover the recent yield curve inversion of the 10-year less 3-mth spread and this has historically preceded a recession and has yet to give a false signal.
We review the Austrian Business Cycle Theory (Boom/Bust cycle of monetary accelerations leading to Bust/monetary decelerations) and how tracking the True Money Supply may explain the “predictability” of recession via the yield curve slope.
Changing growth rates in the Austrian “true money supply” (TMS) monetary aggregate correspond quite well with the spread in the yield curve… when the banking system contracts and money supply growth decelerates, then the yield curve flattens or even inverts. It is not surprising that when the banks “slam on the brakes” with money creation, the economy soon goes into recession. The unsustainable boom is associated with “easy money” and artificially low-interest rates. When the banks (led by the central bank, in modern times) change course and tighten money growth, interest rates rise and trigger the inevitable bust. The True Money Supply measure strips out savings elements from M2 money supply such as money market mutual funds and time deposits.
An Inverted Yield Curve and slowing Money Supply growth have been associated with Bear markets that last beyond a year and which are followed by a subsequent recession.
We are seeing a similar setup now, given the tightness of money growth to respond to current high consumer price inflation. Before the equity market forms a bottom, the yield curve must steepen and we should see positive momentum in money growth (which we have not seen quite yet).
We spend a fair amount of time reviewing the past 22 significant S&P 500 equity market drawdowns since 1929 and try to determine if there is an analytical framework with measure to track to help identify market troughs that are safe for investors to buy into. We have asked ourselves the question – did we miss the bottom on October 12th?
Based on our research and analytical framework, we believe we did not, if a recession occurs next year and a recession/growth downturn is expected in 2023.
Equity market drawdowns have been ~45% when bear markets are subsequently followed by a recession. Based on the long-leading indicators, we believe that a growth downturn will occur in 2023. Highly inflationary pre-recession conditions tend to have longer Bear Markets/Recessions (lasting up to 3 years) and recessions tend to slow inflationary pressures.
At its current price, of $3,992, the S&P 500 trades at a forward P/E multiple of 17x. We have reviewed the current consensus S&P 500 Operating EPS estimates for 2023 of $228/share, which have been revised down in recent months and expect to see YoY growth of 2% in 2023 vs 2022, down from 5% earlier in the year. However, given the pace and severity of tightening of financial conditions (US dollar, rates and energy prices) our leading indicators for S&P 500 EPS are pointing to a decline of between 10 to 25% in 2023. The current price declines in the S&P 500 has largely been due to P/E multiple compression due to higher rates, and have not considered the potential drop in earnings into 2023. This represents further downside risk to equities at this point.
Equity markets tend to peak about 10 months before a recession when the pre-conditions are highly inflationary and it appears that we may be heading in this direction in early 2023 based on our long-leading indicators.
Equity markets typically do not bottom before unemployment begins to tick up. 65% of Peak-to-Trough losses occur after the unemployment rate exceeds the 12-mth moving of the unemployment rate with a median loss of 24%, so we still have downside risk here. We have yet to see the unemployment rate cross over its 12-month moving average.
Equity market troughs tend to occur within 4-6 months of the official recession or first 20% of the recession (before unemployment rate peaks) and when long-leading indicators point upward. We have yet to see our long-leading indicators pick up (i.e. yield curve steepening, positive momentum in money growth etc.) and they continue to deteriorate. Buying in at market troughs tend to be where investors make a lot of money with 5-year annualized returns in the S&P 500 being about 10% per year.
We also reviewed our inflation gauge based on leading indicators and note that inflation is expected to decelerate over the next 6-12 months. We also note that unit labor costs grew YoY at ~6% and remain well above trend growth of 1.1%, though growth is starting to dissipate which should reduce any further concerns around a wage/price spiral. As we have discussed before, wage gains if offset by productivity gains may not be highly inflationary, however, we have noted that much of the wage gains in the last 12-18 months have not been offset by higher productivity, resulting in higher than anticipated inflation.
The US dollar momentum has waned in recent weeks and traders have reduced their speculative positions in the US dollar. Historically, when the US dollar momentum begins to weaken in this part of the cycle, safe havens such as bonds/gold tend to start to rally as they start to anticipate increases in monetary inflation in the next 6-12 months to offset the expected disinflation we may start to see into Q1/23. We expect to see these assets play a larger role in our trend-following portfolio allocations.