The market’s collective psychology dramatically shifted in June. Previously investors were uncertain as to whether the global economy would tip into recession. The Federal Reserve’s decision to raise rates by 75bps at its June meeting and to signal that the path of interest rate tightening would be front-end loaded has convinced investors that the economy is facing a significant downturn. Credit spreads blew out and economically sensitive stocks sold off. Investors fear central banks are on autopilot and will only stop tightening when inflation has been wrung out of the system, even if this causes a deep recession.
Until June the moves in economically sensitive sectors had largely been driven by idiosyncratic factors, often related to their pandemic performance. As investors moved to price in a recession, however, the sell-off in cyclical stocks was indiscriminate. Small and mid-cap stocks, which are more heavily exposed to the domestic economy and therefore more vulnerable to an economic slowdown, were particularly hard hit. Whether now is the time to buy or not likely depends on an investor’s time horizon. In the short-term there is likely to be little respite. The terminal interest rate remains uncertain, central bankers are continuing to ratchet up the rhetoric, and stocks need to navigate through an interim results season where earnings are likely to be revised downwards.
Market structure and liquidity played a role to the upside and are having a similar effect on the way down. Taking a longer-term view, however, the upside could be significant. The strong probability is that this is a cyclical, not structural, bear market. Should inflation cool and nominal incomes hold up, the economy could recover sharply. Would this lead to ‘growth’ stocks reasserting themselves? Perhaps in the early stages but the next decade is likely to be characterised by higher inflation and higher discount rates. Investors need to adjust their playbook accordingly.