November 28, 2022
Economic scenario: Given the sharp recent uptick in interest rates, it’s reasonable to expect some form of US recession next year. Over the next ~6 months, we expect continued resilience based on fading inflation, healthy balance sheets and a lack of macro imbalances offsetting tighter financial conditions. Every deep recession from the recent past has included a major macro imbalance. In the late-‘90’s, the macro imbalance came from business overinvestment and in 2006-’07 it was overinvestment in housing. Without macro leverage, we expect a relatively mild recession to begin once consumers deplete excess savings in H2’23. A relatively shallow negative feedback loop would start with fading purchasing power, while sticky wage gains lead to lower profit margins, business cutting back on hiring/investment and back to fading purchasing power. The feedback loop ends once the Fed cuts rates/becomes accommodative sometime in Q1’24.
Implications: If realized, the scenario above means we’re past the peak in bond yields. But a relatively mild recession would generate a relatively mild pullback in nominal and real yields, assuming core realized inflation remains above the Fed’s 2.5% target. The mild pullback in real yields would keep a lid on expensive, non-profitable tech/software multiples. Peak software multiples of ~20x EV/Sales came when 10-year real yields traded at -120bp. Ten year real yields are now at +141bp and software multiple expansion likely requires something below +60bp.