Money Illusion Will Ease Stock Selloff In Recession, But...

Simon White is a macro strategist at Bloomberg.

The next recession cycle and subsequent cycles will be tempered by the impact of inflation.

It's time for a reality check. Inflation has been relatively benign for several decades, and the distinction between nominal and real values is blurred. The emphasis on nominal values has increased. Their divergence has increased as inflation has risen, making it essential to understand real values to navigate the financial markets.

Most investors will likely use the same recession playbook they used in the recent past.

Stocks will drop sharply during the downturn before the Federal Reserve eases up the situation. Inflation is likely to accompany the next recession. This means that stocks may not perform as badly in nominal terms as they did in previous downturns.

We can understand the reason for this by analyzing the price of stocks as the product of P/E, profit margin and revenues.

The rise in P/E has driven the market up this year (led by AI, but now beginning to spread), just as it did in 2019/2020.

The rise in P/E is not likely to last.

The US inflation rate is not yet out. Due to tight labor markets in the US, low productivity, increasing profit margins, and a gradual easing of conditions in China, the US inflation rate is likely to increase by the end the year. This would result in multiples dropping again, and you may suspect that this is a good reason to sell.

It's not as simple when you look at the 1970s.

The market rallied through the entire second half of the decade after the recession in 1974, but the P/E ratio did not reach its nadir until the early 1980s. In the world of real market variables, this apparent paradox is solved.

It is important to note that although P/Es can be viewed in nominal terms, in high inflation periods, it's better to look at them in real terms.

Define the real P/E by the ratio of the price to the book over the return on equity. Real RoEs must remain constant over time, and therefore real P/Es (ex. the tax effect) should be stable.

The second half of 1970s saw a relatively flat real return on equity, as the effect from relatively stable P/E ratios was overshadowed by the increasing real revenue and profit margins that rose along with inflation.

Nominally, the return on equity was respectable (38% between 1975-80).

In the 1970s, nominal P/E ratios declined as bonds became more competitive with equities. Stocks, on the other hand, are a fixed-coupon asset (the RoE) with an infinite duration. Bonds offer the option to renegotiate a coupon at the maturity date of the bond. P/Es fell as a result until real equity yields were sufficiently higher than real bond yields for equities to become attractive.

The stock market did suffer a major blow during the recession of 1974. Today, however, the stock market faces less of a challenge. In 1974, the real rates were higher. In addition, inflation was still increasing, but in the current cycle, the next recession is likely to hit when inflation has dropped.

When viewed over the entire cycle, stocks are not as obvious to sell in a recession.

If they have a milder decline than the average, the history suggests that they will rally during the next period of high inflation.

Today, we see many of the same dynamics as we did in the 1970s.

Revenues are also rising rapidly, driven by inflation. The revenue-weighted S&P index recently reached a new record high.

The stock market could be seriously affected if Powell responds to the re-accelerating of inflation by going 'full volcker'. This is unlikely. Volcker's path was dependent on the previous leaders: it took Arthur Burns, William Miller and then Volcker himself to reach a point where Volcker's successor could be mandated to bring about a recession in order to neutralize inflation. Powell hasn't reached that point yet. The Fed may be able to hike rates by resisting rate cuts as the economy slows down, but it will take a while.

I have repeatedly stated that equity markets may perform better than expected in a downturn of the usual type - but in nominal terms only. In real terms, equity is likely to be the worst performing asset class, just as it was in the 1970s (although there may be some variation among different equity sectors).

Old habits are hard to break, and positive nominal returns will likely be met with the same enthusiasm as in days before inflation. But those who live in the real world know better