Asset-management firm Guggenheim has some good news and some really bad news for Wall Street: The coming recession will be milder than past recessions — that’s the good news. The bad news is that the stock market is still likely to suffer a savage beatdown as an economic downturn sets in as early as 2020.
They said a lack of pent-up problems in the housing market and a well-capitalized banking system mean the economy is more resilient. That should be welcome news for risk assets, in the wake of March’s inversion of the yield curve — an apparent harbinger of coming recessions, closely watched by Wall Street types and economists.
However, despite a relatively soft landing for the economy, equity benchmarks are likely to see a severe slump, partly due to lofty valuations and a lack of available fiscal and monetary policy tools, analysts at Guggenheim Investments led by Scott Minerd wrote in a Tuesday research note.
See: With Fed’s cards on the table, ‘not a bad time’ to take profits, advises Guggenheim’s Minerd
Guggenheim says the level of equity valuations going into the recession generally dictates the potential magnitude of the slide in stocks, sometimes more than other standard economic metrics.
“Our work shows that when recessions hit, the severity of the downturn has a relatively minor impact on the magnitude of the associated bear market in stocks,” they said.
Currently, the S&P 500 SPX, +0.35% and the Nasdaq Composite Index COMP, +0.69% are within 2.6% from their respective all-time highs put in last year, even after the worst annual return by those benchmarks since 2008 and the ugliest one-day slide on the trading session before Christmas on record.
Easy-money policies, which have resulted in yields on global bonds remaining ultralow, and in some cases negative, have been credited with underpinning the long-lived uptrend for stocks that took hold in 2009 as investors piled into assets perceived as risky in the hunt for richer returns.
However, many view that dynamic as unsustainable, given where it has taken stock values.
“Given that valuations reached elevated levels in this cycle, we expect a severe equity bear market of 40–50 percent in the next recession, consistent with our previous analysis that pointed to low expected returns over the next 10 years,” Guggenheim said. Those predictions amount to a severe bear market, defined as a downturn from a recent peak of at least 20%.
A popular measure of stock values, the Shiller CAPE ratio, show that price-to-earnings, or P/Es stand at 31.05, compared with a historical average of 16.61. The measure was developed by Nobel laureate economist Robert Shiller of Yale University and compares the price against inflation-adjusted earnings over the previous 10 years.
Guggenhim analysts compare the current market set up with the dot-com bubble, which saw exuberant investors plow cash into equities, amid frenzied appetite for highflying technology shares. Though, the economic dent from the implosion of tech was short-lived, the S&P 500 experienced a nearly 50% decline during that rout.
Guggenheim Investments
Another element that might deliver an added kick in the shins to bullish equity investors is a lack of additional policy tools available to both the Fed and Washington to stem any sharp market downturn pullback.
Although, the Fed has scaled back its crisis-era asset portfolio, it still stands at around $4 trillion and the central bank has said it plans on halting its unwind of that balance sheet as a part of a wait-and-see posture that it adopted back in January (and reaffirmed in March) following the market’s late-2018 skid.
The Fed has lifted the fed-funds rate to a range of 2.25% to 2.50% in the current tightening cycle, delivering a total of nine increases since the end of 2015. If, as bond investors expect, the Fed has delivered its last rate increase of the cycle, the rate sits sit well below the terminal point of the previous tightening cycle. That leaves little in the way of monetary policy ammo for the next downturn.
“Even with another hike or two in this cycle, per the Fed’s March 2019 Summary of Economic Projections, the Fed would have less than 3 percentage points of rate cuts available to combat the next recession,” Guggenheim analysts said.
Read: Guggenheim’s Minerd says despite yield-curve inversion, Fed won’t be able to resist urge to raise rates in 2019
And as one of the leaders of the global financial cycle, China’s ability to prop up its economy has offered hope to investors in the event of a global recession. But public debt levels remain elevated following a parade of fiscal and monetary stimulus executed by Beijing.
“When the global economy slows, Chinese policy makers are unlikely to deliver nearly as much stimulus as last time around, even if China manages to avoid a debt crisis or “’ard landing’ scenario,” Guggenheim said.
A dollop of stimulus in the U.S., in the form of late-2017 corporate tax cuts, doesn’t help either, the strategists said, pointing to the effect of driving up the deficit.
Tax cuts and discretionary spending increases passed at the end of 2017 means the U.S. is expected to rack up more than trillion-dollar annual deficits from 2022, according to the Congressional Budget Office.
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