CEOs are preparing for recession

Stock markets have been booming in the green.

This week, investors have been buzzing with comments from various Fed members about how the market may be underestimating their tightening intentions. This kind of oration is part of the communication of central bankers. However, it should be remembered that a year ago the same people were shouting about how inflation was transitory. Of course it is, but the time scale has stretched a tiny bit. Even central bankers are having to accept to economic realities and talk of ever-tightening monetary policy is a bit silly, given the weakening economic environment and already slowing inflation.

I must briefly point out that European stock markets have outperformed their American counterparts since the beginning of the year. You wouldn’t have believed this at the beginning of the year if you had known in advance about the war in Ukraine and Europe becoming a target of Russia's energy weapon. At the same time, inflation in the Eurozone has burst. The German DAX index and the European general index are down just 10% since the start of the year, while the S&P 500 is down almost 20% (in local currency).



In this post, we talk about how CEOs are preparing for a recession. Such preparedness easily becomes a self-fulfilling prophecy. Then there are a few shorter flashes such as inflation in the Eurozone, ballooning consumer credit and falling margin debt, which usually point to good places to buy.

Eurozone inflation eases

In the much-complained Eurozone, upward pressure on prices appears to be easing. In countries such as Spain and Germany, inflation figures are starting to ease. In the Eurozone as a whole, inflation was 10% in November. That's a lot, but the figure was below expectations. This was the first time in 16 months that inflation was below expectations, in which sense this is really encouraging, although the 10% annual rate is still very brisk.

 
On a monthly basis, prices actually fell by 0.1%. This reinforces the narrative that inflation is peaking globally. From an optimist's point of view, equities anticipate a normalization of the price environment, which would provide a basis for valuation multiples. If this trend continues, there will be little talk of inflation in investment circles next year.

The question mark is how long its descent to more tolerable levels will continue. Right now, the expectation is for a relatively quick drop in a couple of years, and if that doesn't happen, stocks are in trouble.

Softening inflation gives the European Central Bank some breathing room. The funds rate has been hiked sharply this year from -0.5% to 1.5%. Here are the current interest rate expectations in the market. The funds rate looks set to rise to just under 3% next year, and no higher. The Eurozone is in a very difficult situation if inflation doesn’t take off with this medicine because the debt problem is knocking at the door in a higher interest rate environment.



Use of margin debt decreases

A feature of the late bull market is that investors try to leverage their returns with debt. In greed, nothing is enough. Debt is a brother at the time of taking and a nephew at the time of paying. In a bear market, the shares backing the debt fall and the shares are forced to be sold so that the broker doesn’t sell off the portfolio.

From this graph you can clearly see how the amount of margin debt has changed. It's currently falling at an annual rate of 30%. Such sharp falls will of course hit bear markets. In general, buying shares is a good idea when others are forced to sell them, and a bad idea when everyone buys them, even with debt if they don't have enough money.



In the last two big bear markets, the amount of debt practically halved, as did the stock markets. If that's where we're headed, breaking the piggy bank is hardly the worst idea at that point.

Consumer credit is still under control

One bearish argument for the souring of the economy has been the credit card spending of the driver of the global economy, the American consumer. It's easy to paint dramatic pictures on the subject, such as this one showing the absolute amount of credit card debt. It's now almost 1,000 billion dollars and on a rocket-like trajectory. This must mean that current consumption is the last unsustainable debt-driven breath of the bull market.

Let's not be so quick to jump to such a radical interpretation. First, Americans' debt service costs relative to income are still very low, as you can see from this graph. They remain historically low at 10% of disposable income.

It should also be mentioned in passing that payment delays are also at historically low levels. Although, these have seen a slight uptick recently.

 
Secondly, consumers still have a lot of credit available. They use only 21% of all credit, compared to an average of 24% before the pandemic. The level of credit card debt is therefore tending towards the old equilibrium, rather than inflating at an alarming rate.



Credit card debt is also ultimately a relatively small part of the total debt. This graph shows total household debt. It is 16,500 billion dollars. Most of the debt is mortgage debt, with credit cards and other consumer debt being a smaller part of the total.



That's a lot in absolute terms, but if you compare it to the size of the economy, it's less dramatic. In practice, the size of the economy has grown significantly since the financial crisis, while household debt has not. This compares the combined debt of households and non-profit organizations to GDP. In practice, households have been reducing, not increasing, their debt ratios for the past 13 years. Thus, household debt should not be a problem, at least not immediately, even if interest rates rise sharply.

CEOs are preparing for recession

A common theme in the stock market recently has been that things are fine for equities, as long as inflation continues to recede and the economy doesn’t go into recession, which would destroy earnings. But the CEOs who run listed companies don’t seem to have the same confidence in the robustness of their profits.

This graph juxtaposes the Conference Board CEO sentiment survey with the year-on-year change in S&P 500 EPS. As you might notice, you can twist the scales to make them rhyme with each other. In general, CEOs' itch of the future has been a good predictor of performance, for better or worse. Now more for worse.



According to the latest survey, only 5% of CEOs see the situation improving and the same small number see the environment improving in the next 6 months. 98% of CEOs expect a recession in the US, 99% in the EU. The US recession is expected to be mild, but in Europe the majority fear a deep recession, which isn’t so surprising in the shadow of the energy crisis. Fewer and fewer report that demand for their companies' products has improved, but not worsened either. Most don’t expect price pressures to ease this year either.

The mood of CEOs is significant in the sense that they are hardly standing on their hands in anticipation of a recession, but with bonuses in their eyes they are rushing to adjust their business. If they start cutting spending and investment at the same time, that in itself could push the economy into recession. Expectations can become a self-fulfilling prophecy. Confidence being at such a low level has virtually always predicted a recession, at least over the past 20 years, as can be seen from this graph.

However, it's worth remembering that equities do anticipate earnings and recessions, and in principle the 10-20% dip in the index level seen this year may have already anticipated earnings taking this beatdown. Stocks are therefore likely to already be looking beyond it, unless its depth and length surprise negatively in a real way.

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