Financial markets are full of warnings about past performance not being an indicator of future performance. But past precedent can be invaluable in preparing for the future, and history certainly gives useful indicators of what is likely to happen next in markets, says Chad Padowitz, co-CIO at Talaria Capital.
“We firmly believe that history is of particular importance in markets today. The majority of people investing in the current market, or advising clients on how to manage their finances, have never experienced more than one tightening cycle, and didn’t live through the global financial crisis (GFC). As a result, few today can draw on deep personal experience to navigate the latest tightening cycle and its aftermath, so learning about the past is the only way to understand the current situation, and to appreciate what might happen in the future.
“As investment managers, the brutal truth is that we are playing a game, albeit a very serious one. We are making decisions in an environment of uncertainty, always taking into account odds and probabilities.”
Mr Padowitz says at the moment, the higher for longer interest rate - and the recession – narrative, seems largely to have been priced out of markets. But this situation is actually against the odds.
“US markets in particular are pricing in rate cuts this year alongside a double-digit reacceleration in corporate profits.
“While we recognise that anything can happen, we believe that many commentators are being excessively optimistic. The end of a tightening cycle has prompted relief rallies before, but they do not change our assessment of the outlook nor the potential for it all to end in tears.
“So what does history tell us? Focusing on the largest and most important economy and stockmarket, and assuming that rates in the US have peaked, there are a few useful indicators.
“First and foremost, history suggests that US earnings and GDP recessions are more likely than not. Following the 13 tightening cycles since 1954, in all cases the ISM manufacturing index (which is a leading indicator of where the economy is going) fell below 50, which is where it currently sits. In 12 out of 13 cases there was an earnings-per-share (EPS) recession and in 10 out of 13 cases there was followed by a GDP recession.
“The year that bucked the EPS trend was 1994, but this was a time when real earnings were well below the historical average, which is not the case now.
“Instead, we believe that earnings per share and the S&P 500 are likely to fall materially, and that income, value and low beta should outperform.
“Furthermore, we suspect the biggest surprise will be that growth is a factor to avoid. This is because in anticipating slowing but still expanding GDP, investors have bid up the shares of companies they perceive to have structural or resilient growth. From here the path to outperformance for these equities in a post peak rate world is narrow. This is especially the case because growth is cyclical.
“We also believe that the strong equity market performance at the end of 2023 and so far in 2024 has misled investors and analysts, who are how embracing what has been called an ‘immaculate slowdown’, where interest rates decline but corporate profitability grows. History tells us that a downturn in earnings is inevitable and this will puncture the latest, far from unique relief rally.
“On the plus side, the strength in markets offers an opportunity to rebalance into our recommended factors of value, short duration, high income as a component of return, low leverage and low beta assets,” Mr Padowitz says.
He adds that all broad equity classes are more expensive than they were five years ago, but the return profiles have changed significantly.
“For example, US equity now yields less than sovereign bonds, investment grade bonds and cash. This is confusing for anyone used to the idea of an equity risk premium. For those seeking to rationalise this, there are ways including tech-related new paradigms such as AI. But the simple explanation is that US shares are just very expensive at the moment. They have been driven up by tailwinds such as wage costs and rates of taxation and interest. These tailwinds are now reversing.”
