Welcome to RBC’s Markets in Motion podcast, recorded June 14, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. This week in the podcast, some quick thoughts on US equities in the aftermath of Friday’s hot CPI print and subsequent sell-off. Three big things you need to know: First, the recent rise in long-run inflation expectations in the University of Michigan Consumer Sentiment Survey suggests that Value oriented sectors may continue to lead for a bit longer. Second, our look back at the historical playbook for US equities around recessions provides some insight into how low the S&P 500 could go. Third, our weekly sentiment indicators continue to highlight the deeply negative views that already pervade the investment community.
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- Starting with takeaway #1: the rise in long-run inflation expectations in the University of Michigan Consumer Sentiment Survey on Friday suggests that Value oriented sectors may continue to lead for a bit longer.
- One thing that seemed to really alarm our economics team on Friday, even more so than the CPI print itself, was the move up in 5 year inflation expectations in the University of Michigan Consumer Sentiment Survey to 3.3%, well outside the range it’s been in for quite some time. Our US economist worries that this unanchoring of inflation expectations will lead to the Fed hiking even more aggressively than many market participants had previously believed.
- With this in mind, we dusted off our charts examining how different sectors within the S&P 500 and Russell 2000 tend to trade in relation to trends in 5 year inflation expectations.
- Within Large Cap, Energy, Materials, Financials and REITs display the most positive correlations with long-run inflation expectations meaning they tend to outperform within the S&P 500 when inflation expectations are moving up. On the flip side, Health Care, Consumer Discretionary, and Communication Services have some of the most negative correlations to trends in inflation expectations within the S&P 500, meaning they tend to underperform when inflation expectations are on the rise.
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- Within Small Cap, Energy tends to be the big beneficiary of rising inflation expectations along with Communication Services and Financials, while Health Care and Tech are the sectors that are most likely to underperform.
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- Moving on to takeaway #2: we took a look back at the historical playbook for US equities around recessions…we walk through potential downside levels in the S&P 500 if a recession is coming/starting.
- We’ve been highlighting how if the YTD 3900 low in the S&P 500 from May 19th, which managed to hold on Friday at the close, got broken and the index were to break below 3850 (the outer bound of growth scare territory, i.e. the 2011 and late 2018 drawdowns), there was significant potential downside risk in the S&P 500. Unfortunately, Friday’s developments and talk of 75 basis points hikes was the straw that broke the camels back and the index broke below those levels in Monday’s trading and closed down 22% from the early January high.
- The main downside level we’ve been highlighting is 3200, which would represent a 32% drawdown in the S&P 500 from the early January 2022 high, which is in line with the average recession drawdown in the S&P 500 peak to trough since the 1930’s and similar to the pandemic drawdown of 34%.
- We’ve also started to point out, that there is precedence for US equities stabilizing above that level. The recession drawdowns of the early 1980’s totaled 17% and 27%, and the recession drawdown of 1990 totaled 19.9%. The drawdown we’ve seen so far in 2022 has been worse than one of the 1980’s drawdowns and in the same neighborhood as the 1990 drawdown. A 27% drawdown would take the S&P 500 to just below 3500.
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- Those numbers speak to potential peak to trough moves. When thinking about the damage that could be on done to 2022 on an annual basis, the thing to know is that the S&P 500 tends to fall 7.5% on average in years that precede negative real GDP years. If a recession is coming in 2023, a good starting point for thinking about the year-end level of the index in 2022 would be around 4400 based on this history.
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- We’ve also been talking about recent sector performance in the context of the historical recession playbook. The declines that have been seen in Consumer Discretionary and Communication Services have been getting close to the average decline they’ve seen over the past four recessions suggesting those sectors may be getting close to pricing in recession risks. Most other sectors haven’t come close to their typical recession drawdowns. The gap has been widest in Energy, and we question how resilient that sector can continue to be if a recession is really on the way.
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- Wrapping up with point #3, our weekly sentiment indicators continue to highlight the deeply negative views that already pervade the investment community.
- We’ve talked a lot in the past about how retail investor sentiment has been worse than pandemic lows in the weekly AAII poll, while institutional investor sentiment has fallen sharply in the weekly asset manager positioning data for US equity futures as tracked by CFTC.
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- In the latest updates in both data sets, which reflect trends in place prior to the post CPI sell-off, The latest AAII and CFTC data – which are both reflecting trends in place prior to Friday – were showing some initial signs of recovery off of levels that have been close to or worse than past troughs. It remains to be seen whether that healing process can resume – I think we’ll get a sense of that in next week’s updates which will reflect the reaction to this week’s FOMC meeting.
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- We continue to find it interesting that positioning for Russell 2000 futures has been below financial crisis lows. That’s a part of the market that is often treated as a pure play on the US economy and the CFTC data suggests that capitulation has already been seen there.
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- Note that we continue to keep an eye on the VIX, which hasn’t yet hit levels that have tended to mark it’s peak in the post Financial Crisis environment – this is one sentiment indicator where we may still need to see more evidence of capitulation.
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- The same can be said of the equity put/call ratio, which may also be another source of pent up pain.
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- We’d also like to see bitcoin stabilize, as it has become another helpful indicator of sentiment in risk assets generally.
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That’s all for now, thanks for listening. And be sure to check out our sister podcast, RBC’s industries in motion, for thoughts on specific sectors from RBC’s team of industry analysts.