Stock market: Preparing for the worst

The worst is never certain. But sometimes it does happen Exactly one year ago, the consensus of analysts predicted a recession in the United States (this was not our scenario at Saxo Bank). It didn’t happen. Again, the consensus is that the U.S. economy is expected to go into recession this year. This time, things are different. U.S. Economic Drivers show signs of weakness (household consumption is starting to suffer from the effects of inflation, listed companies are talking more about redundancies than labor shortages in their quarterly report, the manufacturing sector is still lagging behind, etc.). In our opinion, the severity and effect on financial markets of the next recession will depend essentially on the diligence with which the Federal Reserve (Fed) will act once employment shows clear signs of fragility. The money market estimates that the first-rate cut (thus the real monetary policy pivot) could occur next November. Maybe. We have to recognize that this is a distant economic horizon and that nothing can corroborate this scenario. What is certain is that the recession that may occur should have nothing to do with the financial recessions that occurred in 2000 and 2008. Moreover, it will occur against a backdrop of high inflation. Although the inflation peak is certainly exceeded across the Atlantic, there are several signals that inflationary pressures remain (such as the surprising recovery in the real estate market – real estate prices account for 40% of the Consumer Price Index weight). Nevertheless, the Fed will certainly have no choice but to focus on supporting the economy, as it has always done, at the expense of fighting inflation.

The macroeconomic context is somewhat different from previous recessions. On the other hand, so far, the reaction of equity markets has been rather consistent with what has happened in the past. The markets anticipate that the Fed will take a break from monetary policy, which partly explains the increase since the beginning of the year (+6% for the SMI, +14% for the CAC 40 and +2% for the BEL 20, for example). It is probably only when the US job market falls, that equities will drop (the magnitude will, of course, depend on the state of the labor market and the magnitude of the recession). Usually, as soon as the Fed starts a cycle of falling rates, the market recovers. Therefore, if everything goes according to the previous phases of economic turbulence, we can consider that the risk zone for equity markets is rather around the summer and the end of the year.

Mistakes not to be made

For an investor, a recession is always difficult to manage. We will tend to find the miracle solution, the perfect bulwark against macroeconomic risk. Unfortunately, it does not exist. The first sensible approach is certainly not to make these two common mistakes:

• Not being positioned like the rest of the market. It can be upsetting. It can pay off sometimes, but most of the time it fails. At the moment, capital flows are fleeing from small and mid-caps to the more liquid large caps. It is obvious that there are some very nice gems in the small and mid-cap segment. They are often undervalued, by the way. But it is a difficult market and should only represent a marginal part of its exposure. Listed companies in this segment face a variety of challenges. To mention just a few: a pricing power that is generally lower, difficult access to credit (or it often comes down to underwriting ultra-dilutive financing), limited access to financial hedges, an important ESG cost (in %) and above all, less coverage by analysts (which de facto reduces the liquidity of securities).
• Not being aware of the structural changes at work. Many sectors will be impacted by artificial intelligence. As with the arrival of the Internet, there will be trade-offs. Sectors will emerge, others will die. ChatGPT has already made its first victim: Chegg, a company that offers homework assistance for students. In its quarterly publication, the company clearly mentions the significant negative impact that ChatGPT will have on the growth of their customer base. As a result, in a single day, the company’s price collapsed by 46%. For a company with a stock market value of more than $1 billion, such a drop is unusual.

No miracle recipe

In the absence of a miracle recipe, it can be assumed that the strategies of defense against recession that have worked in the past will work again. It is therefore likely that safe havens such as physical silver or the Swiss franc (strong franc policy of the Swiss National Bank) will perform well. The exit from ultra-accommodative monetary policies is also an opportunity to have money in your portfolio. With a yield sometimes of 4-5% guaranteed, sovereign bonds are again attractive, whereas last year we still thought it was an interest-free asset class.

In terms of equities, some sectors are more likely than others to be more resilient (even clearly in positive territory). These are the defense sector (Raytheon, Boeing, Lockheed Martin, Northrop Grumman etc.), health (Novartis, Alcon in eye care, Roche Holding etc.), agri-food and mass consumption (Nestlé of course and L'Oréal, which is also considered a luxury value) or disruptive technologies (ABB in terms of automation and robotics for example). There are also certain values that have the dual advantage of serving as a bulwark against both inflation and recession, such as Air Liquide – a chemical specialist. It is typically the listed company profile that can withstand economic uncertainty: a highly diversified client portfolio, strong financial ratios (net income up 10% and net margin up 11% in 2022 over one year), a pre-COVID expansion strategy to assert its leadership position and take into account the climate and energy transition (industrial focus on hydrogen in recent years). Bonus: Air Liquide also distributes dividends regularly to its shareholders and, for ten shares held, the company offers an additional share.