Observations: Recession and Reversion to the Mean

Observations: Recession and Reversion to the Mean

Adam Sparkman:        Thank you for joining us for this quarter’s observations and global equities and fixed income. My name is Adam Sparkman, and I’m a Client Portfolio Manager with Thornburg Investment Management.  Today, I’m joined by our coheads of investment, Ben Kirby and Jeff Klingelhofer.  Jeff, Ben, thanks so much for being here today.  I think we’ll start off with maybe one, for both of you.  So, the yield curve has inverted sharply over the past year.  PMIs have remained below 50 now, for 10 months and many other leading indicators have been flashing red for what seems like most of 2023.  So, despite all these signals, where’s this recession that everybody’s been expecting.

Jeff Klingelhofer:        Yeah, I think, coming into this year we certainly expected a much slower economic environment, lower growth, and I think a number of the signals that you point out, if we don’t see a recession, this time around, it will be the first time in history that many, or even individually, any individual one of these indicators has failed, to ultimately lead to a recession.  Now that doesn’t mean it’s gonna happen but certainly, not just taken individually, but cumulatively, all of these red-flashing signals hasn’t led to the slowdown that we expected, and so I think where we stand currently, certainly where I stand currently is, we need to continue to look towards the future.  All right, one thing I’ve talked about very recently is, the alchemy of low rates, I think, is over.  The low-rate environment allowed consumers to pull forward a lot of excess demand, allowed corporations to term out their debt, for individual consumers to term out their debt in the form of long, 30-year mortgage rates, etcetera.  I think what this means is, the impact of higher rates isn’t different this time around, what is different this time around is the length it takes for those rates to really have the bite to slow the economy, and we’re starting to see that now.  We’re starting to see a lot of economic indicators turn down, certainly not to current recessionary levels, but I continue to believe it’s around the corner and preach caution.

Adam Sparkman:        Ben, how about you?

Ben Kirby:      Largely echo with what Jeff said, I think that it takes a while for tighter monetary policy to work its way through the economy.  So, you know, look at home, home, uh, affordability.  It’s at a 40-year low, um, that’s really quite exceptional.  It’s hard to buy a house today because prices have gotten, um, elevated and, uh, uh, interest costs, uh, have increased a lot as well.  The cost, uh, on a monthly basis of buying a new car, is up 30 to 40 percent.  So, volumes of cars and autos are slowing significantly, that’s just one example of how higher rates is taking a little bit longer to work through the economy but eventually, it will continue to slow things.

Adam Sparkman:        So, Ben, international stocks have lagged those in the U.S., year-to-date, despite showing some pretty durable performance during 2022 selloff.  We’ve talked about, really for a while now, that valuations outside of the U.S. certainly look attractive.  Do you think that international can finally catch some performance momentum?

Ben Kirby:      Yeah, you know what’s interesting about international stocks versus domestic, is the international sector doesn’t have, uh, the ten big mega-cap companies that are inventing AI and, and, uh, you know, sort of changing the world in those ways.  If you just look at the other companies, so look at maybe the S&P on an equal-weighted basis, which is just a backhand, uh, way to de-emphasize those mega-cap companies.  Earnings growth, for the S&P equal-weighted, has been very similar to earnings growth for the European industries over the last couple of years and yet, even though you’ve had similar earnings growth, you’ve had about, 13 percent return in European stocks and about 35 percent return in the equal-weighted S&P.  So, you’ve had a lot of multiple expansion, um, in the equal-weighted S&P.  I think that’s one of the opportunities, um, certainly, evaluation is compelling, but you’re also seeing still very reasonable earnings growth, um, out of the European and, and, uh, international companies in general. I would add to that, currencies, uh, which are not a great predictor of near-term returns but on a long term, currencies tend-to-mean revert, and a tend-to-mean revert is something called purchasing-power parody, which is just looking at the price of a good in one country, ex, uh, for exchange rate, should be the same in another currency.  And on that basis, the Japanese Yen is about 40 percent undervalued, and the Euro is about 25 percent undervalued.  So, the dollar is expensive versus those currencies.  The Brazilian reais is about 40 percent undervalued.  The Chinese Renminbi is also undervalued.  So, the dollar is strong.  So, to me a big part of the, the case for international diversification, right now, is earnings growth has been very similar to the equal-weighted S&P, and the dollar looks relatively strong versus history.  Those things tend to mean revert over the long term.

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