“That hurricane is right out there down the road coming our way. We don’t know if it’s a minor one or Superstorm Sandy. You better brace yourself.”
Jamie Dimon, 1956 – present, CEO of JPMorgan Chase, warning investors to prepare for an economic ‘hurricane’ at a Bernstein conference in June 2022
ARE WE HEADED FOR A RECESSION?
In 1966, four years before securing the Nobel Prize for economics, Paul Samuelson famously quipped in a Newsweek article that declines in U.S. stock prices had correctly predicted nine out of the last five recessions – a biting verdict on the market’s clairvoyance. He neatly summarized the much greater volatility of stock prices and warned against relying on the market as a forecaster of the economy.
But don’t rely on economists to give you an early warning either. A review of the past suggests that economists have an even worse record, particularly when it comes to predicting downturns. Unlike the stock market, they are more likely to miss recessions than to predict ones that never occur. In 1929, for instance, the Harvard Economic Society declared that a depression was “outside the range of probability.” Whoops!
Few areas in economics are as controversial as economic forecasting, which is the process of attempting to predict or anticipate future economic conditions by using various economic variables and indicators. These forecasts generally center around predicting the growth in Gross Domestic Product (GDP) for an economy and play a vital role in many economic policy decision-making processes, particularly in the areas of monetary and fiscal policy.
Economic forecasting and financial markets are also closely intertwined as the business cycle is one of the most important drivers of investment performance. It is therefore essential for investors to have a well-informed view on the business cycle so that portfolio allocations can be adjusted accordingly. While techniques have evolved over time, economic forecasting continues to be fraught with difficulty as most data about the economy are lagging and incomplete.
The shortcomings of economists are in the spotlight again as there are pervasive, and increasingly pronounced, signs that a recession may be on the horizon. Slow to recognize the inflation threat that emerged just over a year ago, the central bank has started to aggressively tighten the monetary reins. Inflation rose at the fastest pace in over 40 years in May, with the Consumer Price index (CPI), which tallies the cost of a basket of goods, surging 8.6% from a year earlier. Single-family home prices rose 1.7% in April for a year-on-year increase of 21%. In an effort to combat surging food, housing and energy costs, the Fed raised its short-term benchmark interest rate by three-quarters of a percentage point in June - its largest rate increase since November 1994. That follows a quarter-point increase in March and a half-point jump in May.
With investor expectations fluctuating between continued high inflation and an economic downturn caused by a hawkish (i.e., favoring higher interest rates) Fed, the S&P 500 experienced its worst first half of the year since 1970. Through the end of June, the broad benchmark index dropped 21% and tumbled into bear market territory – defined as a 20% drop from a recent high. Other major indices, like the Nasdaq and Russell 2000, have never experienced worse starts to a year than this. Ten-year Treasury yields, which are a barometer for mortgage rates and other consumer loans, surged to as high as 3.5% last month, from just 1.5% at the end of 2021, before falling to 2.97% to close out the quarter. This is the first time on record that the market has started the year with both the S&P 500 and the Bloomberg Barclays Aggregate Bond Index down over 10%.
The Fed’s promise to do “whatever it takes” in its fight against soaring inflation has sparked fears that higher prices might be conquered only through aggressive rate hikes that will imperil the economy. According to Google Trends, search activity for the term ‘recession’ is at the highest level of 2022 and is now on par with searches for the term back in 2008 and 2009 when the domestic economy was officially in a recession.
Fed Chair Powell’s explicit acknowledgment that steep interest rate hikes could drag the U.S. economy into a recession only added to the uncertainty. In his semi-annual testimony before the Senate Banking Committee, he admitted that the task of orchestrating a soft landing - the sweet spot between taming consumer demand and inflation without crushing economic growth - was going to be very challenging. Each rate hike means higher borrowing costs for consumers and businesses, which results in a drop in spending and weakens overall economic vigor.
Indeed, since 1955, every time inflation exceeded 4% and unemployment fell below 5%, the economy has tumbled into recession within two years, according to a paper published this year by former Treasury Secretary Lawrence Summers and his Harvard Kennedy School colleague Alex Domash. The U.S. jobless rate is now 3.6%, and inflation has topped 8% every month since March.
The economy is already slowing down from the post-pandemic surge. In the first three months of the year, the U.S. economy unexpectedly contracted at an annual rate of -1.6%, its first decline since the pandemic-induced recession in 2020 and a sharp reversal from a 6.9% annual growth rate in the fourth quarter. The Atlanta Fed’s GDPNow model sees Q2 real GDP shrinkage of -1.0% as of June 30. While that is not necessarily a harbinger of future economic distress, the decline has fueled fears that a recession - defined by some as two consecutive quarters of negative growth - could be on the horizon.
Even a potential second-quarter rebound in GDP won’t necessarily be enough to assuage fears of a recession later this year or next, as it’s unclear how long consumer demand will remain strong as they spend down excess savings accumulated during the pandemic. For now, many consumers can cover price hikes by tapping into a larger than usual savings cushion from wage gains and a flood of pandemic-related stimulus money. However, the personal savings rate, as a percentage of disposable income, fell to 4.4% in April, the lowest level since 2008, according to the Commerce Department. That’s half the rate it was in December, and roughly a third of where it was the year before.
In June, the University of Michigan’s closely watched Consumer Sentiment Index fell to its lowest level on record going back to 1952, reflecting that elevated prices for gas, food, and other goods and services are weighing on Americans’ mood (see top graph on this page). Retail sales fell in May, the first decline this year, and job and wage growth has slowed. A souring mood for consumers is a concerning sign because household spending accounts for about 70% of U.S. economic output.
Mounting recession concerns are also top-of-mind for businesses. The National Federation of Independent Business (NFIB) reported that its May small business optimism index fell to its lowest level since April 2020 (see bottom graph on this page). The share of owners expecting better business conditions over the next six months has deteriorated every month since January and
dropped to the lowest level recorded in the 48-year-old survey.
Economic history suggests that aggressive rate hikes could be necessary to finally control inflation. Typically, that will require raising interest rates to a level that restricts growth, brings down wage inflation, and helps reduce demand across the economy - all without pushing the economy into recession. Based on Summers’ and Domash’s analysis of 70 years of efforts to do so, the Fed probably can’t prevent a recession. Already, economists surveyed by The Wall Street Journal have dramatically raised the probability of recession, now putting it at 44% in the next 12 months, a level usually seen only on the brink of or during actual recessions. And a recent Deutsche Bank survey revealed that about 90% of investors expect the U.S. to enter a recession before the end of 2023.
Of course, whether or not those concerns prove to be correct remains to be seen as we can’t predict economic trends with great confidence. It’s certainly true that a recession is more likely now than it appeared six months ago. The main catalyst for most US recessions that have occurred in the post-war period was a rise in interest rates in response to inflationary pressures, which caused a sharp decline in demand for goods and services. It is often said that economic expansions rarely die of natural causes; instead, they are killed by some kind of policy error.
Even so, it’s not all doom and gloom out there. Consumers are on solid footing, the job market is tight, and most workers are earning higher wages. Restaurants are thriving while air passenger volumes and hotel occupancy rates are returning back to pre-pandemic levels. An economy with strong employment and spending can withstand a lot of shocks.
With the probability of a recession on the rise, investors naturally have questions about what this means for their portfolios and how to best prepare for that possibility. Here are some steps you can take to ensure you are well positioned to manage a period of economic difficulty:
First of all, what is a recession?
President Harry Truman reportedly said: “It’s a recession when your neighbor loses his job; it’s a depression when you lose your own.” A somewhat less subjective definition of a recession is ‘two consecutive quarters of negative GDP growth.’ However, the National Bureau of Economic Research (NBER), which officially declares the starting and ending dates of recessions, defines them ‘as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.’
In other words: a recession is a significant, widespread and extended decline in economic activity. Symptoms include faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and declining sales and production.
What should investors do during a recession?
Recessions are uncomfortable, but they are a normal part of long-term investing. Since they are identified with the benefit of hindsight months after they begin, the worst of their impact on markets has usually passed by the time one is officially called. That’s because the stock market is generally recognized as a leading indicator of economic cycles and habitually leads the general economy by several months, both in upswings and downturns. Specifically, equity markets routinely top out before the start of recessions and bottom out far in advance of their conclusion.
While it would be ideal to avoid recessions and market declines altogether, the reality is that they can’t be reliably predicted or timed. We also need to be mindful that no two recessions are created equal. Neither does a bear market always signal a recession. That is precisely why it’s important to always be prepared for a market or economic downturn rather than trying to predict one. Study after study over the years has shown that ‘market timing’ doesn’t work and that ‘time in the market’ is what matters. Historically, every major U.S. stock market downturn has been followed by an even bigger upswing. It may take time for the market to recover, but if you have the stomach to wait out a downturn, the long-term results should work in your favor.
Looking at both bull and bear markets for the S&P 500 going back to 1942, First Trust found that the average Bull ran for about 4.5 years, with an average cumulative return of 153.7%. The average Bear Market lasted roughly 11.3 months, delivering an average cumulative loss of -32.1% (see graph above).
The duration and magnitude of individual bear markets have varied significantly, but the years immediately following them have historically offered strong returns. Stocks are forward-looking, so when the market does turn, it typically turns very quickly, and a significant portion of the gains frequently accrue during the early months of a stock market rally. Investors who miss that moment may miss some of the greatest positive returns.
In today’s uncertain environment, we are reminded of a quote from Benjamin Graham, who is considered ‘the father of value investing’: “In the short run, the market is a voting machine, but in the long run, the market is a weighing machine.” He was referring to the key difference between the ‘price’ and the ‘value’ of a security. In the short run, the market votes on which firms are popular and sends stock prices up and down accordingly. But in the long run, the market has to assess the underlying fundamentals of a company to give its true weight, or value. The wealth that a company creates will find its way to shareholders over the long-term in the form of dividends and stock price appreciation.
As we have pointed out in previous newsletters, ‘buy and hold’ doesn’t mean ignoring your investments! Depending on your life stage and financial situation, there are steps that can help investors weather a prolonged market downturn - and potentially even benefit:
• Avoid knee-jerk reactions. Investing is a long-term strategy that will always be visited by pullbacks, recessions, and incredible stages of growth. Investors should avoid attempting to ‘time’ the market or make material adjustments to their portfolios. While staying the course and continuing to invest even when markets dip may be difficult, it can result in greater accumulated wealth over time.
• Revisit your goals and risk tolerance. Now is the time to proactively revisit your investment strategy. Your risk tolerance is your ability to emotionally handle big price swings. If you are tempted to push the sell button reactively when the market falls, this might be a timely opportunity to adjust your portfolio’s risk tolerance.
• Rebalance your portfolio to maintain your target asset allocation. Because the relative performance of various asset classes will vary, portfolios tend to drift from their target allocation. Rebalancing brings your portfolio back to its original asset mix to restore the appropriate risk level. Our firm is dedicated to review your portfolios on a periodic basis and to rebalance them when needed to maintain their strategic long-term allocations in the face of rapidly shifting markets.
• Find strategic opportunities. Recessions impact various sectors of the economy, and the stock market, differently. Rather than speculate about whether or not a recession is pending, patient investors should remain vigilant and monitor the market landscape for opportunities to invest in high-quality assets at discounted prices for long-term growth. Importantly, pursue maximum diversification, including by sector, market capitalization, and region. Exploiting market dislocations during periods of volatility are the building blocks of long-term wealth creation.
• Maintain a long-term perspective. Recessions can be painful, but investors should be comforted that economic declines have historically been relatively small blips. Over the last 65 years, the U.S. has been in an official recession less than 15% of all months, with the average recession lasting just under a year. Maintaining a balanced, well-diversified portfolio for the long run is a tried-and-true process to achieve meaningful returns.
• Your financial adviser is here to help! One of the key benefits of working with a financial adviser is that they can assist you in creating a solid long-term investment strategy for your personal situation to help you grow wealth over a longer period of time. They can assist you in establishing a well-diversified portfolio and advise you on how to finetune your strategy in accordance with your specific situation. They can also provide historical context so that you don’t have to make decisions with a long-term negative impact based on heightened emotions or a fear of financial loss. For more on how we are guiding your portfolio through this market cycle, please contact your experienced Telos financial advisor.
Most importantly, remember that both your long- and short-term investment decisions should be based on your financial needs and your ability to accept the risks that go along with each investment.
Benjamin Franklin once said: “By failing to prepare, you are preparing to fail.” With inflation running at a 40-year high, major geopolitical disruptions around the globe, and monetary and fiscal policies in flux, investors, if they haven’t done so already, should prepare their portfolios for an environment of more risk, less liquidity and higher rates. If you have an appropriately diversified portfolio that matches your specific goals, time horizon and risk tolerance, you will have the peace of mind of knowing that future market volatility shouldn’t affect your ability to achieve your goals over time.
On a personal note, we are excited to announce that Bryton Czerwinski has joined our firm as a Client Service & Operations Specialist on our marketing team. He recently graduated Cum Laude from California Baptist University with a BS in Finance. Bryton will support our office operations with administrative tasks and work closely with our marketing team to facilitate client requests and deliver on our commitment to outstanding client service. As our firm continues to grow, we are pleased to provide our clients with top-notch talent and service. JULY 2022