Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Drawdown lessons: Look at market dynamics and ignore the economy
Peter Garnry
Chief Investment Strategist
Summary: The US equity market is in a bear market despite strong economic activity confusing many investors. The reason for this is that the equity market is initially responding to tighter financial conditions causing the cost of capital to go up which then compresses equity valuations. The 1973-1974 drawdown also started with strong economic activity levels for almost a year while the equity market fell until the economy eventually fell into a recession succumbing to inflationary pressures. Could this drawdown cycle be similar to the 1973-1974 drawdown cycle?
Is the current drawdown a replay of the 1973-1974 drawdown?
This Monday we wrote an equity note on historical drawdowns in the S&P 500 and the importance of putting weight on the right historical samples for guiding investment decisions in the current drawdown. Our conclusion is that the past 12 years drawdown dynamics are the wrong ones to emphasize relative to the dot-com bubble drawdown and the two drawdowns during the early 1970s. Seen in that light, the worst might be ahead of us and the current drawdown could extend much longer than what most market participants are currently expecting.
Something we have alluded to in our daily Saxo Market Call podcast this week is that the US economy is still strong, something JPMorgan Chase CEO Jamie Dimon also emphasized yesterday, and that we highlighted in yesterday’s equity note. This might be a confusing element for many investors. Why is the equity market panicking when the economy is so strong relative to past trend growth? The simple answer is that financial conditions have tightening at a record pace and inside that process increased the cost of capital causing equity valuations to compress.
If we look at the 10 drawdowns since 1968 with a maximum drawdown of more than 10% then we observe the striking feature that in four of those 10 drawdowns the US economy was actually growing above trend growth in the entire period to the trough of the drawdown cycle. The period with the highest economic growth during a significant period of selloff is the 1983-1984 drawdown of a little more than 10%; here the economy did well, but equities were repriced following a strong 1982-1983 period as financial conditions came down, but around a 300 basis points move in the US 10-year yield from the summer of 1983 to the summer of 1984 changed equity valuations and took equities down. However, the economy was strong enough to absorb these higher interest rates.
We have talked a lot about the 1973-1974 drawdown because of the similarity in terms of explosion in inflation from low levels and the similarity of an energy crisis (this time a broad-based commodity crisis). If look at the entire 1973-1974 drawdown to the trough then it was during a time of strong economic growth in the US. As the table below shows, the CFNAIMA3 (3-month average in the Chicago Fed National Activity Index – a Fed measure of economic activity) was positive for 12 months while the S&P 500 was in a drawdown. It was not until one year into the drawdown cycle that the economy finally decelerated and eventually went into a recession. The current drawdown has similar characteristics with the US economy being strong four months into the drawdown, but as we are arguing the tighter financial conditions and the Fed’s inflation battle will kill demand eventually and thus a replay of 1973-74 could likely play out over the next year.
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