The sky is falling

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  By Guest Blogger Doug Rowat

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A storm’s upon us.

The Fed unexpectedly slashed its benchmark overnight rate by 50 bps last week, a magnitude of cut almost exclusively reserved for times of crisis and which strongly suggests that the US economy is in much more need of help than previously thought. In early August, the Cboe Volatility Index (VIX) spiked intraday to almost the 66 level on recession fears, reaching its highest level since the Covid crisis and setting an all-time intraday record in the process. Until recently, the 2-year and 10-year US Treasury yields had been inverted for more than two years, which is about as reliable a recession predictor as Cristiano Ronaldo scoring on a penalty kick (85%).

Thus, many investors argue that, never mind a coming recession, the US is already IN recession and therefore an equity bear market’s imminent.

But is it?

Let’s look first at the Fed’s interest rate policy. The onset of an easing cycle (even one that starts with a 50 bp bang) is almost always positive for markets. The below table illustrates how the S&P 500 typically performs following the Fed’s first rate cut. Not only is the S&P 500 positive, in aggregate, over every subsequent time period (3, 6, 9 and 12 months), but it averages a double-digit gain 12 months following the cut:

The first cut is the sweetest: Fed interest rate policy and the S&P 500 performance

Source: Dynamic, Deutsche Bank

The recent volatility spike’s not much of a bear-market harbinger either. Quite the opposite. Normally, the VIX hovers in the 10-30 range, but occasionally, as we saw in August, it spikes massively. However, these large volatility surges historically indicate strong future S&P 500 returns. When the VIX enters the 60+ range, again, as it did in August, the S&P 500 advances 35% on average 12 months out (see chart below). Of note, when the VIX hit its all-time high in March 2020 during the Covid crisis, rising above the 82 level, the S&P 500 was up more than 70% a year later.

A fear index or an opportunity index/ S&P 500 forward returns at different VIX levels (1990-2024, daily frequency)

Source: KKR

Finally, there’s the dreaded inverted yield curve. While the 2-year and 10-year US Treasury yield curve did remain inverted for more than two years, it’s now dis-inverted (yes, apparently, this is a finance term). The inversion certainly signals a looming (or already existing) US recession, which is undeniably concerning. But remember: the US economy grew 1.6% on an annualized basis in Q1, followed by 3.0% growth in Q2. Further, the dis-inversion, meaning the 2-year Treasury yield has now returned to being lower than the 10-year, could be positive for markets, at least over the short term. According to Goldman Sachs, the S&P 500 historically trades sharply higher in the six months following a dis-inversion—provided you’re in either the “no recession” or “already in recession” camps:

Median 6-month returns following 2-year and 10-year Treasury yield dis-inversions (since 1950)

Source: Goldman Sachs Global Investment Research

The point here is that all of these apparent storm clouds may actually suggest further upside for equity markets. Naturally, you may argue that this is a hopelessly optimistic view and that it’s naive to consider these warning signs as anything other than prescient recession and bear-market indicators.

And perhaps you’re right. I’ve highlighted before that bad outcomes can occur unexpectedly and are something that investors, and our clients, should be prepared for:

Recessions will rear their ugly head about every six years. Since the late 1940s there have been 12 US recessions. Naturally, the gap between each recession varies as does the length of the recession itself, but if you accept that, more or less, one will occur every six years and also accept a duration of about 10 months you’ll be far less anxious when the next one—inevitably—occurs.

So, perhaps the US is already in recession and the equity market doomed. Or neither may be true. Regardless, this is why we maintain balanced and globally diversified portfolios for our clients.

It guarantees that they’ll own something that’ll benefit from my market view. And from yours.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.