Don’t Mention the “R-word!”
The dreaded “R-word” appears to be back! Investors and business owners are concerned that a recession is likely in 2023, induced by the rapid policy tightening that the Federal Reserve (Fed) must now implement to quell the accelerating inflation we witnessed during the first quarter this year. On top of continued strong consumer demand, inflation pressures were boosted by continued supply chain disruptions —the war in Ukraine has pressured food and energy prices, and the renewed COVID-19 lockdown in China has renewed port backlogs. Inflation expectations are becoming unanchored from the 2% level the Fed targets to fulfill its mandate of price stability — due to wage growth of over 5% in a tightening labor and 8% annualized growth in various price indices.
As result, shorter-term interest rates have risen sharply, approaching the levels of long-term interest rates, causing the yield curve to flatten, and even briefly inverting over several maturities. As we have written elsewhere¹, a significant and sustained inversion of the yield curve is an ominous signal — one that typically presages a recession 12 to 18 months hence. For us, it is such an important and reliable forward-looking message from the bond market that we incorporate it explicitly into our assessment of the valuation of stocks compared to bonds. In this assessment, a significant and sustained yield curve inversion causes our criteria to predict stocks will be more expensive due to the possibility that the Fed will push the economy into a recession to keep inflation expectations in check.
Though we acknowledge the possibility of the Fed making such a policy mistake over the balance of 2022, stocks do not yet look extremely expensive compared to bonds — a precondition for our discipline to lower exposure to risky assets ahead of a sustained stock market bear market, like it did in 2000 and 2008. Corporate profits are still expected to grow even though the cost of capital is likely to rise significantly — a direct result of the productivity growth many companies are experiencing through the adoption of technological advancements that have been accelerated by the pandemic. Virtual communication, automation via robotics, and artificial intelligence have allowed companies across many industries to do more with less.
Our discipline is telling us that it is not yet inevitable that a recession will ensue next year. For one thing, the yield curve needs to invert in a significant and sustained way across several maturities before the shot-clock to the next downturn starts. In addition, there are other measures that may portend a sustained economic downturn is in the cards, such as the spread of corporate bonds over Treasury bonds. These spreads have widened slightly, but not yet to the level that typically corroborates that a recession is imminent. Besides, the labor market remains very strong with jobless claims at a 50-year low — it is rare for recessions to occur without considerable weakness in job growth. Rather, as we have recently described in detail², “stagflation,” a period of slow growth and elevated inflation — but not as painful as the economy experienced in the 1970s — is the most likely outcome over the next 12 to 18 months.
Outperforming a Challenged Public Market Environment
As interest rates jumped, bonds experienced their worst quarter in 40 years, declining 5.9%, and stock markets corrected in sympathy. Assets that are most sensitive to rising interest rates bore the brunt of the selling. These assets include longer-maturity bonds and Growth stocks, whose future cash flows are further out and must be discounted back to the present over a much longer timeframe.
Our strategies have held up relatively well against this challenging market backdrop for several reasons. First, we remain at the low end of our ranges in fixed income. In addition, within stock markets, our emphasis on Value stocks³ and the Energy sector has outperformed in an environment of rising interest rates and higher inflation. This stance has anchored our strategies for several quarters now. In retrospect, our discipline led us to switch our long-standing emphasis from Growth to Value too early last year as successive variants of COVID caused uncertainty. However, through the end of the first quarter, this move has proven fruitful. During the first quarter, while the ACWI benchmark was down over 5%, our equity portfolio was up over 1%. This led to strong portfolio performance in our Growth and Balanced strategies — up over 1% and flat respectively, vs. weighted respective benchmark declines of over 5%.
Second, within this general theme across strategies, we made several moves at the margin to sharpen our emphasis. We reduced the duration of what little we have in fixed income across strategies to lower their sensitivity to further interest rate increases. Within Market Risk, we took profits from our position in the Energy sector as the outsized gains exceeded our target — while our discipline has signaled a sustained period of outperformance from this sector, the surge in oil prices caused by the war in the Ukraine led prices to gain beyond the underlying trend we expected.
We have begun to capitalize further on our long-standing insight that momentum drives return in Market Risk — while valuation is a paramount consideration when assessing how much Market Risk to hold in a portfolio, our allocation is largely driven by which areas investors are rewarding. In certain strategies, we initiated an allocation to an index of stocks showing the strongest price persistence at an individual stock level regardless of whether they are classified as Growth or Value. Our Market Risk now stands to benefit from where momentum is driving returns at different security levels: style (Growth vs Value), sector, capitalization (Large vs Small), and individual security level.
Global capital markets have digested the likelihood that the Fed and other central banks across the world will pivot rapidly from emergency monetary policy in a COVID-19 world to a more neutral stance. They expect the Fed to raise short-term interest rates over the next 18 months to at least 2% and that this will be accompanied by efforts to reduce its nearly $9 trillion balance sheet by selling bonds it bought during the pandemic — to provide liquidity to the economy4.
A period of lower economic growth and lower, but still elevated, inflation is likely to unfold. One or more of the following reasons could help the Fed “thread the needle” by tightening enough to orchestrate a soft landing and eventual decline in inflation without pushing the economy into a recession5:
- Eased supply chain disruptions later this year and early in 2023;
- Accelerated productivity growth helping companies remain profitable as their cost of capital increases;
- Effective monetary tightening — The Fed could successfully tighten monetary policy by balancing the burden between Main Street —through short-term interest rate increases which make auto, student, and mortgage loans more expensive— and on Wall Street — selling bonds on its balance sheet to reduce excess liquidity in financial markets.
Clearly there is a substantial “wall of worry” for stock markets to climb in the coming months. During such unsettling times, it is always helpful to remember that time in the markets, rather than timing the markets, leads to a much higher probability of meeting our investment mandates over time.
Should the outlook deteriorate, we will not hesitate to proactively reduce exposure to risky asset markets when our discipline signals a high probability of a recession and sustained bear market in stocks, like we did in 2000 and in 2007.
Please do not hesitate to call if we can answer any question you may have.
Thank you for the trust and confidence you have put in our team and process.
Adrian J. Cronje, Ph.D., CFAÒ
Chief Executive Officer and Chief Investment Officer
3 Our position in “pure” Value stocks, a basket of stocks that represent the deepest value, has done especially well on a relative basis.
4 This is a reminder that the interest cost of margining portfolios is going to increase significantly over the coming months. Please contact your Relationship Manager to discuss this.
5 There is lot of precedent for this. 6 of the last 15 Fed tightening cycles since World War II have not ended in a recession.
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