After seven years of rising equity markets, the sharp slide seen since the beginning of the year raises the issue of the timing of the next recession. In fact, MSCI World Index declines of more than 10% year-on-year have often been a sign that the leading country, the United States, is about to enter a recession. This is what we have seen going all the way back to the 1970s (See Graph 1), except for the 1987 stock market crash (which was not followed by a recession). Moreover, MSCI World Index earnings are already on a slight downtrend – to the same extent seen when the eurozone fell back into recession in 2012 (less than 10%). Finally, the Fed’s rate hike is yet another factor contributing to the tightening of monetary conditions through the rise of the US dollar, which might be regarded as a monetary policy mistake1 .
This situation, although undoubtedly critical, does not appear hopeless to us in the light of three historical observations which we will examine in this article.
What lessons does the decline in oil prices hold?
As the new year began, oil prices began falling again in earnest, bringing the decline to -75% from their June 2014 peak and to more than -50% year-onyear (See Graph 2). We note that a price decline of this scale, which amounts to an oil counter-shock, has always been followed by a favourable equity market reaction and has even led to the formation of bubbles.
The 1986 counter-shock (November 1985 to July 1986) led to a market exaggeration that culminated in the crash of October 1987. Likewise, the oil price decline of 1997-1998 (from October 1996 to December 1998) preceded the formation of the dot-com bubble of 1999-2000. While the decline in oil prices is mostly due to an excess of supply, one might reasonably conclude that this oil counter-shock, which has been a boon to consumers, will lead to one form or another of market exaggeration.
Lastly, we note that cycle downswings can be frequently seen after an annual rise of 50% or even 100% in the price of oil but never after a decline of more than 50%.
Margins are at record highs in the United States. What to make of that?
This is not a new observation. In fact, business margins in the United States have been at maximum levels since 2012, although it can be argued that they really reached their peak in the third quarter of 2014 (See Graph 3). This also corresponds to the record lows reached by high-yield spreads, which are obviously very sensitive to margin peaks.
We note that for the economy as a whole, historically the median companies’ margin peak occurs six quarters before a recession2. This would suggest an entry into recession… in the first quarter of 2016. However, in the 1960s and at the end of the 1990s, recessions were further apart from margin peaks; to be more specific, 15 quarters. This scenario would push back the onset of the next recession to the first semester of 2018, which would give the market 10 enough time to recover and even produce a few market exaggerations like the 0 ones we referred to above.
Typically, stock market cycle profiles during these prolonged business cycles track higher for at least a year, which would be very much in line with previous observations. In 2006, the bull phase lasted 14 months, from July 2006 to October, 2007. In 1998, the bull phase lasted 18 months, from October 1998 to March 2000.
Lastly, although margins fall during such prolonged business cycles, corporate earnings generally accompany rising equity markets. In 1987 as in 1998, corporate earnings had initially fallen but then began to rise again; as usual, the market ended up anticipating each recovery between one and two quarters in advance. In 2006, there was no break in the upward movement of corporate earnings.
For now, earnings worldwide are on a slight downtrend and we do not expect 100 a sharp rebound. However, it is important to note the wide gap between the earnings of growth stocks, which continue to climb, and those of value stocks, which are falling (See Graph 4). At this stage, the leading companies in this cycle are resistant, which is a precondition for the market to go into extra innings.
How should we interpret the wide gap between growth -50 stocks and value stocks?
Growth stocks are getting a relative boost from the oil counter-shock argument and very low interest rates; the MSCI Growth Index is heavily weighted with consumption sector constituents (information technology, consumer discretionary, consumer staples and healthcare account for 66% of the index). In contrast, value stocks are suffering; they are closely tied to commodities and also include financials (energy, materials, utilities and financials represent 54% of the MSCI Value Index).
The ratio of growth stocks to value stocks has been on an uptrend since 2007 (See Graph 5) and, since mid-2014, it has been increasing sharply (+17%). The panic in August 2015 and the wake-up call early this year have only reinforced this trend, which prompts us to make a few observations:
So is this a cycle downswing or not?
Our interpretation of the three factors above leads us to the following conclusion: equity markets are capable of recovering over the course of 2016 and may even end up in positive territory but they will not in any way exceed their cyclical highs of last year. This assumes a reaction by the monetary authorities and perhaps even the fiscal authorities and, at the very least, the stabilisation of oil prices. In this case, a recession scenario would be delayed until 2017 or 2018.
There could then be a sharp rebound by value stocks, some of which are regularly oversold, especially those tied to the price of oil and industrial commodities. But it will be hard for them to keep pace with growth stocks, whose earnings are climbing. Growth stocks could end up on an “exaggerated” uptrend, at least in relative terms. In an environment where oil prices are particularly difficult to forecast, it is interesting to note that seasonality is usually favourable to oil from February/March until summer.
This scenario, which is consistent with our historical observations, appears to be the most reasonable in our view. However, obviously things may turn out differently. As long as oil is on a downtrend, credit spreads are tightening and banking stocks are under attack, the risk remains high. While the Fed was certainly cautious in January, it was obviously less worried than it was last September, which does not amount to a catalyst as powerful as lowering interest rates, which it had initiated in 1998 during the LTCM crisis. So we cannot really rule out a sharper stress phase before things begin to fall into place.
Although the cycle downswing scenario we describe above may superficially appear to be positive for the equity markets, it is far from being the most manageable scenario. It suggests that without perfect timing, it would be wise to limit the size of our bets. At the regional level, we are maintaining our preference for the eurozone; but this would require the US market to hold steady (which is our scenario, barring a recession in 2016). As to themes, above and beyond the issue of sustainable dividends, which concerns all regions, we remain positive on high-quality US stocks (the most cyclically advanced market), stock-picking in Japan (a more mature market than the eurozone) and,lastly, the “momentum” style in the eurozone. Otherwise, we are still cautious
1- See Discussion Paper DP12: “Central Banks: the First Pillar of the Investment Cycle” – November 2015
The oil counter-shock
The earnings of growth