Market Commentary - Q1 2022 - US Economy now in the late stage of the business cycle
Key Takeaways:
- We believe that the US economy is now in the late stage of the business cycle
- Fed raises rates 0.25% and changes its tone on inflation
- Yield curve hints a recession is 12-18 months away
- Spike in gas prices suggest a recession could be on the horizon as well
- Recessions are painful, but expansions have been powerful and much longer
- Impacts of Russia/Ukraine war on the global economy
- Market outlook and investing playbook
- Ensure emergency funds and cash reserves are adequate for 6-18 months of expenses depending on personal circumstances
- Balance equity portfolios with a mix of quality dividend-paying blue-chip companies and growth companies with quality earnings
- Choose sectors and asset classes with a strong history of weathering market declines
- Stay calm and keep a long-term perspective
We are publishing our Q1 2022 commentary early as we believe there are opportunities that have arisen in the market of which action should be taken now to rebalance portfolios and ensure client’s have ample cash reserves to cover expenses and inflation pressure on rising prices. We will provide a shorter commentary when Q1 comes to a close with year to date updates.
Business Cycle
As a continuation to our research piece and investing thesis of “Seeking opportunities in business cycles”, we believe that the US economy is now in the late stage of the business cycle.
Fed raises rate 0.25% and changes its tone on inflation
On Mar 16, 2022 the Federal Reserve raised its benchmark federal-funds rate by 0.25% for the first time since 2018. Fed Chair Jerome Powell hinted at six more rate increases by year’s end, the most aggressive pace in more than 15 years, in a frantic effort to slow inflation that is running at its highest levels in four decades.
On Mar 21, 2022 Powell gave further comments on the Fed’s plan to combat inflation, stating that the Fed will consider more aggressive interest rate increase (ie. 0.5% hikes) as ‘inflation is much too high’.
The sudden change in tone comes with inflation as measured by the consumer price index running at 7.9% on a 12-month basis. A gauge that the Fed prefers still has prices up 5.2%, well above the central bank’s 2% target.
Powell went on to say, “We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.” These comments sent US government yields even higher.
The Fed and Powell have been given a lot of criticism from economists regarding the transitory nature of inflation. He finally conceded that Fed officials “widely underestimated” how long those pressures would last. Often times, the biggest risk during a Fed tightening cycle is a policy mistake such as reacting too late to inflation and raising rates too quickly as an attempt to play catch up. This dynamic can cause demand destruction, which would create price stability, but also force the US economy into a recession.
The Fed’s task now is to guide inflation down by raising rates to moderate demand but to avoid such an aggressive or rapid response that the economy slides into recession. Powell suggested that it will be a “challenging task” to avoid a recession as they ‘take the necessary steps to ensure a return to price stability.’
Yield curve (2YR to 10YR) hints at possible recession in 12-18 months
A yield curve may sound like an elaborate phrase used by economists, but it is actually a rather simple theory and can be a strong indicator of predicting the next recession. A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates (ie 2 YR US Treasury vs 10 YR US Treasury). The slope of the yield curve gives an idea of future interest rate changes and economic activity.
There are three main shapes of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve), and flat.
While the curves may not be as extreme as pictured above, this gives you a general idea of how the different slopes are defined.
An inverted yield is one of the most accurate and widely cited recession signals. The yield curve inverts when short-term rates are higher than long-term rates. This market signal has preceded every US recession over the past 50 years. Short-term rates typically rise during Fed tightening cycles.
Yields on US Treasurys largely reflect investors’ expectations for short-term interest rates set by the Fed over the life of a bond. At the start of an economic expansion, short-term interest rates are typically low. But investors expect them to rise eventually, creating steady upward gaps between short- and long-term yields, or what investors call steep yield curve.
Even if short-term rates are seemingly stable, investors have typically demanded higher yields on longer-term bonds as compensation for the risk of unexpected inflation and corresponding rate increases.
The yield curve inverts when short-term rates are higher than long-term rates. This market signal has preceded every US recession over the past 50 years. Short-term rates typically rise during Fed tightening cycles. An inverted yield curve portrays that investors demand a higher yield for short-term bonds as there is greater default risk in the short-term than there is in the long-term, hence why long-term yields are lower than short-term yields.
Spike in oil prices suggest a recession could be on the horizon as well
While the yield curve is flirting with inversion, we believe that the spike in energy prices and other commodities, such as wheat, fertilizer, and other food items resulting from the war in Ukraine, will have increased pressure on inflation for a longer time period than initially predicted and puts central banks in a very difficult position, ultimately forcing the global economy into a recession in the next 12-24 months by rapidly raising interest rates.
Sharp rises in gas prices have been indicators of recessions in the past as consumers feel the pain of higher prices, however Fed Chair Powell contrasted the potential shock to inflation from a surge in a broad range of commodities, including energy, due to the Ukraine war with the oil-price shocks from geopolitical events in the Middle East in the 1970s. That history was “not a happy one” for the Fed, as it led to double-digit inflation, Mr. Powell said. The shock in Ukraine is “more like a classic supply shock that you would tend to want to look through,” Mr. Powell said. But he said the Fed was less inclined to ignore the shock than it might otherwise have been because high inflation risks leading consumers’ and businesses’ expectations to rise to levels that could create a much more destabilizing psychology of higher prices.
We believe that the additional supply chain bottlenecks and rise in already elevated commodity prices will have an impact on inflation that will force central banks to tighten into a recession in order to achieve price stability. Consumers will feel the effects of higher prices just as the summer travel season approaches, putting travel, leisure, and hospitality industries at even more risk after two extremely difficult years following the pandemic.
Recessions are painful, but expansions have been powerful and much longer
If a recession is on the horizon, the good news is that they generally don’t last very long. Analysis by Capital Group of 10 cycles since 1950 shows that recessions have lasted between 8 and 18 months, with the average spanning about 11 months. For those directly affected by job loss, business closures, or early retirement, that can feel like an eternity. For these investors, sufficient cash reserves is the most important protection they can have during uncertain times. Having ample cash reserves enables investors to not be forced to sell equities to raise cash during a down market and stick to their long-term financial plans. Investors with a long-term investment horizon would be better served looking at the bigger picture.
Recessions are relatively small blips in economic history. Over the last 65 years, the US has been in an official recession less than 15% of all months. The net economic impact of most recessions has been relatively small as well. The average expansion increased economic output (GDP) by 25%, whereas the average recession reduced GDP by less than 2%. Equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.
While the exact timing of a recession is hard to predict, it can be wise to think about how one could affect your portfolio. That’s because bear markets and recessions often overlap, with equities leading the economic cycle by six to seven months on the way down and again on the way up.
During a recession, the stock market typically continues to decline sharply for several months. It then often bottoms out about six months after the start of a recession, and usually begins to rally before the economy starts humming again. (Keep in mind, these are market averages and can vary widely between cycles.)
Impacts of Russia/Ukraine war on the global economy
While equity markets have historically powered through geopolitical events, we believe that the Russian invasion of Ukraine will have a long lasting impact on inflation and global economies.
Commodity prices jumped to multi-year highs after Russia invaded Ukraine, raising the prospect of tighter supplies due to the possibility of additional sanctions on Russian exports, transport disruptions and Moscow withholding supplies.
Russia supplies 10% of the world's oil, a third of Europe's gas and, together with Ukraine accounts for 29% of global wheat exports, 80% of sunflower oil exports and 19% of world corn exports.
Beyond global spillovers, countries with direct trade, tourism, and financial exposures will feel additional pressures. Economies reliant on oil imports will see wider fiscal and trade deficits and more inflation pressure, though some exporters such as those in the Middle East and Africa may benefit from higher prices. Steeper price increases for food and fuel may spur greater inflation across the globe as well.
We believe that the additional supply chain bottlenecks and rise in already elevated commodity prices will have an impact on inflation that will force central banks to tighten into a recession in order to achieve price stability.
Outlook
While investors shouldn’t panic and sell all of their stocks in preparation of a potential recession, there are certainly reasons for concern and recession risk is elevated.
Investors shouldn’t react emotionally or aggressively when rebalancing portfolios to reduce risk exposure. Aggressive market-timing attempts, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. It’s often better to stay invested to avoid missing out on the upswing.
However, investors at or near retirement should be cautious and look to build cash/safe-haven reserves with equity markets near all-time highs after a tremendous bull run as inflation risks continue to put the economy at risk.
As interest rates continue to rise and inflation persists, we are still overweight US equities as they provide strong inflation protection overtime.
Even in years with normal to strong equity returns, there are still rolling waves of volatility and multiple corrections. That being said, it is perfectly normal to feel uneasy about market pullbacks resulting in a lower portfolio value in the short term. It is important not to react to these pullbacks and to keep in mind that volatility is common and to be expected.
Stay calm and keep a long-term perspective. In the long run, discipline breeds success.
Investing Playbook
Reduce technology exposure to market weight or underweight
- We still believe in a long-term technology exposure, however we believe investors should look to pair back overweight technology exposure on any relief rallies in the Nasdaq and allocate these proceeds to less interest rate and inflation sensitive parts of the market.
Reduce exposure to China and Emerging Markets after a strong bounce from bottoms
- Headline risks involve geopolitical tensions with China and inflationary pressure on EM countries.
Increase cash reserves and cash positions in investment portfolios
- The most important and impactful resource to weather the storm of a recession is having ample cash reserves to avoid being forced to sell equities in a down market to raise cash for living expenses.
- Investors should ensure their emergency funds and cash reserves are adequate for 6-24 months of expenses depending on personal circumstances.
Increase allocation to sectors and asset classes that historically perform well during times of high inflation and rising interest rates
- Financials - rising rate environment should lead to increased profits
- Quality large-cap and blue-chip, dividend paying stocks
- Materials - industrial metals, agricultural commodities, energy, chemicals, precious metals
- Diversified Real Estate - multi-family, commercial tied to supply chain and warehouses.
There are not many catalysts for a strong market rebound in the near term and we are approaching an earnings season that has the potential to be extremely volatile
- What would propel equity markets to new highs other than an end to the war in Russia/Ukraine which doesn’t seem to be happening any time soon. The likelihood of a prolonged, drawn out war is far more comprehensible which would continue to push inflation higher for an extended period of time.
- We are approaching another earnings season that has a high possibility of elevated volatility. Most earnings calls have not mentioned a slowdown in demand due to rising prices, however we are starting to see demand destruction with elevated gas prices and if demand destruction or shrinking margins are seen in other sectors of the market, we believe this can initiate another broad equity market sell-off.
As always, if you have any questions, or would like to discuss your portfolio/current situation, please feel free to set up a call by clicking here.
