Many indicators of past economic slowdowns are now sounding an alarm. Yield curves in most major economies around the world are inverted. Leading economic indicators and business sentiment surveys have negatively triggered. Signs of stress in the financial system are emerging. Our own Economic Composite (TEC^TM) alerted us to a potential recession in the U.S. and several other countries in the second half of last year. S&P 500 earnings expectations for 2023 have declined 11% since last June. A recession appears imminent.

Unemployment is near record lows, though a lagging indicator and typically at its nadir at the end of the business cycle. Cracks are appearing; employers are becoming increasingly cautious, with numerous companies announcing layoffs, hiring freezes, or restructurings. Unemployment may not rise as significantly as in past recessions for various structural reasons, but a rise should be expected. Recent quarterly earnings calls have been anything but upbeat regarding the general near-term outlook.

Despite these bright red lights, investors appear sanguine. The implied growth embedded in U.S. equities is presently a lofty 4.7% (see Chart 1, below). While down from the peak of 6.3% registered before the 2022 correction (when we argued that equities were the most expensive in history), equity valuations imply smooth sailing ahead for the U.S. economy. However, we know from history that recessions are rather unfavourable for equity prices—since 1965, two-year rolling losses of 20% or more have always been closely preceded by a peak in the business cycle.

CHART 1. S&P 500 IMPLIED GROWTH. MARCH 31, 1999 to MARCH 10, 2023

SOURCE: FACTSET, GENERATION PMCA

How do we explain the disconnect between the high implied growth rate and blinking red lights?

1. Markets expect a soft landing

While most economists expect a recession in the next 12 months, the unemployment rate is forecast to peak at only 4.9%, well below prior cycles. This implies a shallow recession, cooling inflation, limited interest rate hikes, and cuts as early as the end of this year. In other words, a soft landing. Equity investors buying stocks at this juncture expect to skate through just a small bump in the road, with the dangling carrot of monetary policy tailwinds heading into 2024.

2. Complacency—ignorance is bliss

Even a cursory examination of historical bear market declines reveals a recurring pattern—markets contentedly ignore troubling economic data points until the evidence is overwhelming (usually accompanied by a galvanizing catalyst). Then markets quickly unravel, often in a waterfall pattern, a stark contrast to the upward meander during economic expansions.

In 2006, then Federal Reserve Chairman Ben Bernanke famously shrugged off the inverted yield curve as a harbinger of a slowing economy. In 2019, Bernanke’s successor, Janet Yellen, also dismissed the inverted yield curve while our own Economic Composite was alerting us to a pending recession.

In Chart 1, elevated implied growth can be seen before the 2001 and 2008 recessions—all while troublesome economic data points were piling up.

High valuations and weakening economic data warrant caution. We continue to hedge (shorting equity indexes) against broad market declines as the economic picture worsens. On the long side, we own companies that have demonstrated the ability to generate high returns on invested capital throughout an economic cycle or unique situations—restructurings, spin-offs, merger arbitrage, corporate activism—which may work even as the economy deteriorates. Companies less tied to the business cycle should be emphasized, such as consumer staples, telecommunications, and health care, since these groups tend to outperform in recessions.