The potential for the US economy to enter a recession increased substantially in the first half of 2022. In this article, we provide some thoughts about the potential for a recession, the general state of the US economy, and what that means for investors and their portfolios.
Are we in a recession or just headed for one?
Based on several leading indicators, the US economy is likely facing what might be the most anticipated recession in decades. CEO and small business confidence surveys are on a steep downward slope, and the Purchasing Managers Index, a leading indicator of prevailing economic trends, has sharply declined since its mid-2021 peak. Additionally, inflation is at early ‘80s levels, gasoline prices are nearing $5 per gallon, and just buying paper towels and toilet paper costs substantially more now than this time last year, putting the domestic economy top-of-mind for most of America. Even the Atlanta Fed’s GDPNow, a live GDP expectations calculator, predicts a second consecutive quarter of negative GDP growth in the US.
Against this relatively bleak backdrop, however, we see signs that the anticipated recession may be more of a soft landing rather than a hard one.
- Corporate earnings expectations really haven’t changed much, although economists widely believe that downward revision is inevitable as the average decline in corporate earnings during a recession has been 14% for the past 70 years. The approximately 20% decline in the S&P year-to-date has already taken into account some portion of the expected earnings decline, which has been reflected in P/E ratio compression up to this point.
- Corporations are enjoying record-high margins, healthy balance sheets, and abundant cash, so they are better positioned to absorb some challenges without necessarily taking draconian corrective measures.
- We still have over 11 million job openings in the US, which, when compared to the roughly 6 million unemployed, means that we have 1.8 jobs for each available worker.
- Labor has power that it has not had since maybe the early ‘80s, and with that often comes wage growth. While this increased cost is not great for the corporate bottom line, the top line may not suffer because that wage growth ultimately accrues to the consumer.
- Despite worrying about a recession and being fairly angry about prices at the gas pump and on the Charmin, the consumer is still relatively healthy with a stockpile of savings from fiscal stimulus, strong home prices and a feeling of job security.
- Consumers are spending freely as well, although they are using credit more aggressively this year, much of which is visible through credit card data, but an unknown amount is also growing via “buy now, pay later” options that don’t provide consistent reporting.
As far as caveats go, there are certainly factors that could undermine the soft-landing scenario. The war in Ukraine is still a significant exogenous wildcard where, in addition to the risk of military escalation in Europe, issues such as European energy vulnerability and the potential for significant economic shock remain. Russian natural gas is critical to Germany, Italy and other countries, and a major disruption in supply could lead the Eurozone into a deeper recession than anticipated. The stalwart US consumer underpins the soft-landing scenario and has been resilient in the face of inflation, rising rates and geopolitical volatility. Significant retrenchment by the consumer would materially alter expectations for the depth and length of the much-anticipated US downturn.
Inflation and the Fed
Headline US inflation is a major concern, and the Fed has aggressively taken up arms in defense of price stability in earnest for the first time in many decades. In response to rising prices, the Fed has employed the loudest weapon in its arsenal, the Fed policy rate, as the strongest signal of its commitment to suppressing inflation. In the span of three meetings, the Fed raised the policy rate from 0% to 1.75% and is likely on track to reach 3% by September.
The challenge with this approach is that inflation is typically broken down into three parts (demand-driven, supply-driven, and “ambiguous”), and changing the policy rate disproportionately targets the demand side of the inflation equation by increasing the cost of money. The recent increases in inflation, however, have been disproportionately driven by the supply side of the inflation equation. Thus, the Fed policy rate may not actually have much impact on overall inflation because, as we know, supply chain issues, tight labor, the Ukraine war and commodity shortages have played a potentially larger role in the level of inflation today. The Fed has been open about this dilemma too, as evidenced by Chair Powell’s comments during a June 29th European Central Bank forum, when he stated, “I think we now understand better how little we understand about inflation.”
At that same forum, Powell also stated, “The US economy is actually in pretty good shape.” By many measures, he is correct, but aggressive policy targeting demand could undermine that strength without necessarily solving the underlying problem. The Fed is in a bind and cannot sit on its hands in the face of 9% headline CPI, although it can make a powerful opening salvo, look for any positive signs (whether causal or coincident from their policy) and then point to the positive sign as success. Recent data indicate that some of the supply-driven pressure on inflation may be abating a bit, which could provide the opening for the Fed to reassess further tightening and bring full employment back into the conversation.
Alternatively, the inflation pressure could continue, and the Fed would need to show its resolve by tightening further to remain credible. Will Jay Powell have a Volcker moment? In 1980 and 1981, the Volcker Fed raised the policy rate to a level above headline CPI. A very aggressive tightening program, in excess of what has been communicated, may have unintended consequences beyond quashing demand, potentially leading to a hard-landing scenario.
What does this all mean for investors?
Our philosophy is now and has always been to maintain the discipline to stick to a long-term plan and not make decisions based on daily (or weekly) market volatility. In that regard, over the past year, we have advised most clients to position their portfolios at or below target to public equities (keeping potential tax consequences in mind). For clients who are building equity positions, we advise adhering to the pre-determined schedule and continuing to dollar cost average into the market. These are uncertain and, in many ways, unprecedented times when being patient and opportunistic is of the utmost importance in constructing and maintaining investment portfolios.
While we remain cautious about capital markets pricing, given that the Fed’s tightening program is still underway and visibility on its conclusion and impact is still hazy, equity and fixed income markets, in particular, have adjusted considerably since year-end.
- We believe that an attractive entry point to add certain risk assets (e.g., equities) is likely to come at some point this year, and we are far closer to fair value now relative to 1 year ago and the beginning of the year.
- The near-zero interest rate environment of the post-COVID period has also passed. Yields on Treasuries with maturities beyond one year are currently above 3% and corporates, mortgages, municipal bonds, etc., all provide considerably more income potential than just six months ago. Real yields remain negative though, so the path of inflation over the intermediate and longer term will be an important determinant of fixed income performance going forward.
- In an environment where real returns matter, real assets have a significant role to play. Specific real estate sectors, agricultural assets, and infrastructure are generally positively correlated with inflation and also align well with potential global structural and demographic changes.
- Private equity and venture capital markets have repriced dramatically as well, and the upside potential available to nimble and focused investment teams should be improved as a result. As the falling tide lowers all boats and the poor ideas are washed out, the remaining opportunity set should provide managers with better potential investments at lower entry multiples.
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