After the mayhem in the markets there has been a week of calm. The American markets have clawed back a bit of their losses this year, and the Footsie – which had not fallen nearly so far – has settled well above 7,000.
But it is an uneasy calm. The R-word – Recession – keeps popping up in the commentaries here, in the US and in Europe. Paul Drechsler, former president of the CBI and chair of London First, warned of recession, saying the ‘key questions are how deep and how long’.
Jay Powell, Federal Reserve chair, told the US Senate committee that recession was ‘certainly a possibility’. And in Germany Deutsche Bank’s chief executive, Christian Sewing, reckoned that there was ‘at least a 50 per cent chance of a recession globally but also in Europe’.
R-word: Recession keeps popping up in the commentaries here, in the US and in Europe
Until there is some clarity for the global economy there won’t be clarity for global equity prices. The problem is simple. Take the most basic measure of value for shares, the price/earnings ratio. Values are reasonable by recent historical standards, with the S&P500 of US shares on a ratio of around 20, and the FTSE100 on 14. The prices are not dirt cheap but they are not outrageously expensive.
But what will happen to earnings? If there is a brief and shallow recession, in aggregate they probably won’t fall much. Companies are already moving to protect margins and many have pricing power. But a serious recession, coupled with higher funding costs, would inevitably undermine earnings.
That would push up the ratio, making shares look expensive again. There is a further twist. Valuing shares is not just about the ratio, dividend yields, price-to-book, BEER (the bond equity earnings yield ratio) or all the metrics that have been developed by the professionals to justify the prices.
There is also a thing called sentiment, those swings from optimism to pessimism that seem embedded in human nature.
The famous economist John Maynard Keynes dubbed the positive phase as people being driven by ‘animal spirits – a spontaneous urge to action rather than inaction’. Right now it is rather the reverse. Given the relentless flow of troubling news on just about every front, we animals want to curl up in our dens and wait for the dangers to pass.
That applies to us as investors but also as consumers. If we cut back on our spending, and consumer sentiment has been hammered here in the UK and elsewhere in recent weeks, that leads to recession. We do not need all the grandees to tell us to be glum. We are perfectly capable of being glum without their advice.
So what will signal that it is safe for us to peek out from our dens, sniff the air, realise that the storm has passed, and watch asset prices climb again? We are not at that point yet, but at some stage it always comes. Turning points can take two forms. There can be some cathartic moment. The most recent occurred in March 2020. People first were overwhelmed by fears about the pandemic and shares plunged. Then, on the 23rd when for one day the Footsie closed below 5,000 – 4,993.89 to be precise – they started to realise that this was a once-in-a-decade buying opportunity.
The other is when the general sense of depression lifts so gradually that we are hardly aware of it happening. There is no particular reason for the shift. It is when there is lots of negative news interspersed with the occasional bright spark. It is conceivable that we are already in that trough now and that by the autumn we will be more cheerful. I have to acknowledge that it doesn’t feel like that yet, but my guess is this will be one of those gradual recoveries in sentiment rather than anything sudden. If that is right, we should expect it to be associated with a year of mediocre economic performance rather than a sharp, deep recession.
This surge in inflation is caused more by shortage of supply than excessive demand. Supply chains will gradually be rebuilt. The airlines will figure out how to hire enough people. I hope desperately global food supplies will be adequate to get the emerging world through the winter. We know that the world economy, for all its extraordinary complexity, is also extraordinarily resilient.
So I think the turning point in market sentiment will come when we become aware of that resilience and focus on that, rather than the troubles of the next few months. Meanwhile, stand by for many more stories with the R-word in them.
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