Summary of Key Points
- As core inflation remains stubbornly high, and the Federal Reserve continues to implement aggressive monetary policy tightening, we see higher risk of a recession over a shorter-term (12-month) horizon.
- While equity markets have sold off over the past several weeks from their mid-summer highs, we recognize that earnings estimates revisions could continue to adjust downward as third quarter results are announced.
- In the meantime, core bond yields have risen materially this year and now provide a reasonable alternative to equities.
- We rebalanced portfolios during the quarter, further reducing Emerging Market equities.
Third Quarter Market Recap
After a very difficult first half of the year, equity markets rebounded in July and August on investor hopes of an easing in inflation and a Fed pivot or pause. The reprieve was short-lived however, as stocks tumbled to fresh lows in late September amid further aggressive central bank rate hikes and statements of further tightening to come.
Global stocks fell 6.8% for the quarter and are down 25.6% for the year. The S&P 500 dropped 4.9% for the quarter and is down 23.9% for the year. Developed international markets fell 9.4% for the quarter and 27.1% YTD. Emerging Market stocks dropped 11.6% for the quarter, and down 27.2% YTD.
Foreign equity market returns for U.S. dollar-based investors were worsened by the sharp appreciation of the dollar. The U.S. Dollar Index was up 7.1% for the quarter and a stunning 17.3% on the year, hitting a 20-year high. These dollar gains translate into roughly comparable losses for U.S. dollar-based investors investing in international equity markets. For example, the MSCI EAFE Currency Hedged Index return this year is -13.0% vs. -27.1% unhedged; and the MSCI EM Currency Hedged Index has lost about six percentage points less than the MSCI EM Index unhedged (our benchmark). A reversal in the dollar would be a major tailwind for unhedged foreign equity returns going forward.
Core investment-grade bonds didn’t avoid the Q3 carnage. The 10-year Treasury yield hit a decade high of 3.97%, causing the Bloomberg U.S. Aggregate Bond Index (the “Agg”) to drop 4.8%. This puts the “safe-haven” Agg down 14.6% for the year to date. In other segments of the fixed-income markets, high-yield bonds dropped 0.6% and floating rate loans gained 1.4% for the quarter. For the year to date, floating rate loans have been one of the best performers, down just 3.3%.
Our allocations to “non-traditional” asset classes — non-core fixed-income market segments and alternative strategies – benefited our balanced portfolios again in the third quarter.
Macro Outlook: Increasingly High Risk of Recession as High Core Inflation and Aggressive Fed Tightening Persist
Inflation
The economic backdrop for the U.S. and global economy deteriorated further in the third quarter, continuing a trend we highlighted last quarter. Stubbornly high Inflation remains the key economic indicator. High inflation is driving U.S. and global central banks’ to further tighten monetary policy and hike interest rates. Central banks are raising their policy rates (the “fed funds” rate for the U.S. Federal Reserve) to attempt to bring down inflation by curtailing “aggregate demand” – consumer and business spending.
The Fed’s policy hammer of higher interest rates will eventually pound down GDP growth and increase unemployment. The odds the Fed can engineer an economic soft landing — where the U.S. economy slows to below-trend GDP growth with somewhat higher unemployment but does not fall into a deep recession with much higher unemployment – are increasingly slim.
While headline CPI inflation (excluding food and energy) seems to have peaked, core inflation measures have continued to rise and are far above the Fed’s 2% target. This indicates inflationary pressures have become more widespread throughout the economy, rather than driven by a few extreme outliers as in 2021.
As such, and as expected, at its September 21 meeting, the Federal Open Market Committee (FOMC) raised the fed funds rate by 75 bps to a target range of 3.0% to 3.25%. The FOMC’s new median forecast is for another 125bp (1.25%) increase over their next two meetings in November and December, ending the year between 4.25% and 4.5%.
The FOMC also sharply cut its GDP growth forecast to just 0.2% for 2022, and a sub-par 1.2% in 2023. The long-term trend U.S. GDP growth rate is estimated to be around 2%, based on expected U.S. labor force and productivity growth rates.
It’s worth reminding ourselves that just nine months ago at its December 2021 meeting, the FOMC’s median forecast was for the fed funds target range to be 0.75% to 1.0% at the end of this year, with real GDP growth a very strong 4.0%. Little more need be said about the Fed’s (or anyone else’s) ability to predict key macroeconomic variables consistently and accurately over time.
In addition to higher rates and lower growth, the FOMC also increased its unemployment rate forecast, to 4.4% next year. If that plays out, history suggests a recession is likely. Since 1950, there has never been an instance where the U.S. unemployment rate has increased by a half percent or more from its cycle low without an accompanying recession. The unemployment rate bottomed at 3.5% in July.
Two key inflation variables the Fed is focused on are (1) the labor market – wage inflation specifically – and (2) inflation expectations. The data here continue to be mixed.
Wages: U.S. wage growth (wage inflation) is high and still rising. The U.S labor market remains very tight. The 3.7% unemployment rate is near all-time lows, while the ratio of Job Openings to Unemployed workers looking for a job remains near all-time highs at 2-to-1. This suggests continued upward wage pressure is likely at least until the labor market materially weakens, which is the Fed’s aim.
Inflation Expectations: On the positive side, consumer surveys and market-based measures suggest medium-to-longer-term inflation expectations remain well-anchored, consistent with the Fed ultimately achieving its 2% core inflation objective. Short-term inflation expectations, which are highly sensitive to gas prices, have also dropped recently.
Inflation expectations are crucial, because if they become unmoored they can feed into a self-perpetuating, inflationary wage-price spiral, where wage and price hikes feed back into higher inflationary expectations which feed into further wage and price hikes, etc. This was essentially the inflationary regime that Fed Chair Paul Volcker had to break in the early 1980s. One huge difference (among many) between now and then is that medium-to-longer term inflation expectations reached double-digits in Volcker’s time – requiring a double-digit fed funds rate to ultimately crush — versus their 2-3% range today.
Inflation is not just a U.S. problem. Nearly all global central banks (except Japan and China) are raising their policy rates to fight inflation in their countries. This will depress global aggregate demand and economic growth over the shorter-term.
Economic Growth
Along with persistent core inflation, the shorter-term growth outlook has worsened for the U.S. and most of the globe. In our Q2 commentary we highlighted two widely followed economic indicators that are published monthly: the Purchasing Manager Indexes (PMI) and the Conference Board’s Leading Economic Index (LEI). Both measures continued to deteriorate in the third quarter and are now signaling a recession is likely coming down the pike.
We put particular weight on the LEI – the “granddaddy of leading indicators.” In addition to the magnitude of its recent decline, the LEI has dropped for six straight months (and will again in September). That has never happened before without a recession.
Of course, no leading indicator is 100% foolproof. There are way too many non-stationary variables that impact economies and financial markets for that to be the case. But the LEI has an excellent track record.
A third time-tested recession indicator is the Treasury yield curve – specifically whether and to what extent it is inverted, meaning shorter-term yields are above longer-term bond yields. An inverted yield curve is unusual and usually a leading indicator of recession. But not always, and the timing from inversion to onset of recession has been highly variable historically. Nevertheless, the 2-year/10-year yield curve is strongly inverted at -50 bps. This degree of inversion has never occurred without a subsequent recession and is another piece of the puzzle that leans recessionary.
While we weigh the evidence as leaning strongly towards a U.S. recession, there are still some positives supporting the economy and that may mitigate the severity of a recession if/when it happens. To wit: the strong labor market and wage growth supports consumer income and spending; monthly job growth (nonfarm payrolls) has remained robust, increasing by 315,000 in August; weekly new unemployment claims remain very low (though they are ticking higher); there don’t appear to be any major, systemic, economic/financial imbalances (e.g., unlike in 2007-08); and, generally robust household savings and business balance sheets can support additional spending and borrowing.
So again, a recession is not a certainty. A soft landing is still a possibility, with some luck. But we don’t see the current positives as strong enough to offset the economic damage that looms ahead. And to the extent the economy remains strong and the inflationary fire remains stoked, the Fed will have to tighten even more than the markets currently expect. That won’t be good for financial asset prices.
Financial Markets Outlook
Having established an increased probability of a recession over a shorter-term (~12-month) horizon, the next step is assessing whether and to what extent the financial markets, and more specifically the U.S. stock market, are pricing in (“discounting”) a recessionary scenario.
Shorter-term S&P 500 Downside Risk Analysis
From the table on the following page, we can see that the range of recessionary bear market declines has been very wide, from -20% (in 1990) to -57% (during the 2008-09 financial crisis). As we discussed in our Q2 commentary and noted briefly above, we think a repeat of the severity of the 2008-09 bear market is unlikely because we do not see anywhere near the systemic financial and economic imbalances now compared to then. Nor do we see the degree of “irrational exuberance” that existed prior to the bursting of the tech bubble in 2000 leading to that period’s 49% market drop.
Economic recessions are typically associated with a significant drop in corporate earnings (negative EPS growth), i.e., an earnings recession. So, a second approach to estimating the potential bear market decline is to estimate the likely impact on corporate earnings and valuations, and then derive the trough S&P 500 level from those estimates.
The current bottom-up consensus estimate is for an 8% increase in S&P 500 Operating EPS for 2023. Analyst earnings estimates for 2023 have started coming down over the past few weeks, but the market is still far from discounting anywhere near a 10-20% earnings decline at its current level.
Our equity strategy group will be closely watching this quarter for any changes in estimates.
Relative Attractiveness of Stocks Versus Bonds
For a while we have argued that while U.S. stocks have not looked compelling on an absolute expected-return and valuation basis, they were still relatively attractive compared to the extremely low yields on core bonds. Put differently, the extra earnings yield we expected to earn on stocks compared to core bonds – the “equity risk premium” — was sufficiently high to somewhat favor equities.
However, with the sharp rise in core bond yields this year – to above 4% — that has changed. Stocks no longer look cheap relative to bonds, as can be seen in the chart below. They are around their long-term average equity risk premium relative to bonds.
With their higher current yield, core bonds now also offer better portfolio ballast and shorter-term return potential in a recession scenario. For example, if the 10-year Treasury yield were to decline 75 bps (to 2.75%) over the next 12 months, we estimate the core bond index (the Agg) would return roughly 8% (from yield plus price gains). That would be in the neighborhood of a 30 percentage point advantage versus the equity market if stocks are down 20%-plus from here. Even if Treasury yields rise 75 bp from here, for example in a “stagflationary recession” scenario, we estimate the Agg Bond Index total return would still be slightly positive, around 1%.
Portfolio Positioning
During the quarter we repositioned many of our balanced portfolios to underweight international equities overall relative to our strategic benchmarks. EM equities were again adjusted lower during the quarter in favor of U.S. equity.
While core bonds have become more attractive given their higher yield, we continue to have a meaningful allocation to actively managed flexible bond funds, run by experienced teams with broad investment opportunity sets. There are many fixed-income sectors outside of core bonds that offer attractive risk-return potential, and we want to access those via our selected active managers.
Closing Thoughts
From a macroeconomic perspective, U.S. core inflation remains stubbornly high. In response, the Federal Reserve continues to implement aggressive monetary policy tightening and is unlikely to stop until there is clear and consistent evidence that inflation is falling towards their 2% target. This will take a while and there is a good chance, given the long lags for the effects of monetary policy to fully flow through the economy, that the Fed will tighten too much. As such, we see an increasingly higher risk of a recession over a shorter-term (12-month) horizon.
In the meantime, core bond yields have risen materially this year (the Agg Bond Index is yielding above 4%), to the point where equities are no longer relatively cheap versus bonds.
We continue to hold allocations to flexible actively-managed bond funds and alternative strategies/funds where appropriate.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial Group with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.
