Markets, Economy, & Portfolio Management Fall 2022

Market Update

Stocks and bonds posted their third consecutive quarter of negative returns, as aggressive monetary tightening has taken a toll on equity and fixed income valuations. The S&P 500 Index is down 24.9% Year-to-date (YTD). The conventional “all weather” 60% Equity/40% Fixed-Income portfolio is down 20.1% YTD according to Morningstar – worst on record. Higher rates have adjusted valuations down for both stocks and bonds closer to normal levels associated with slow economic growth.

Fast tightening cycles have resulted in Bear markets and recessions. The Federal Reserve (Fed) has embarked on one of the fastest rate hiking cycles since the 1980s. CME Fed Funds Futures point to more rate hikes ahead. Moreover, the Fed is likely to keep rates high for an extended period, even if inflation falls, to make sure it does not stage a comeback as it did in the 1970s when the Fed eased policy too early.
In addition to raising short-term interest rates, the Fed is allowing Treasury bonds on its balance sheet to mature and is not issuing new bonds to replace the retired ones. This is called Quantitative Tightening (Q.T.). It reduces the money supply in the economic system so there are fewer dollars available to purchase goods and services. In turn it will lower goods and services prices, raise borrowing costs, and slow the economy. A research paper from the Atlanta Fed suggests that planned Q.T. is the equivalent of thirty basis points of rate hike. Between Q.T. and rate hikes, financial conditions have become extremely tight overnight. There is a growing risk that the Fed through its actions will not only cause a recession but also break something globally – trigger a credit event in off balance sheet assets.

Earnings growth is following the path of economic growth. A decelerating Global Manufacturing PMI has not boded well for earnings growth. The Global Manufacturing PMI tends to lead the trend in earnings growth for the global companies in the MSCI World Index by about three months according to S&P Global. It is indicating lower earnings in 2023. Earnings growth is still positive for 2022 according to FactSet, but earnings growth among all sectors are quickly losing steam and could turn negative in the first half of 2023 as rate hikes choke economic growth. Analysts are aggressively revising down projected earnings estimates. Typically, the stock market will bottom six months before earnings bottom in 2023.

S&P 500 Index valuation has corrected 34% so far. The S&P 500’s average valuation declines 33% in a garden variety recession. Forward earnings for 2023 are presently trading at 15.2 with earnings expected to grow 6.5% according to CFRA. The U.S. economy must evade a recession in 2023 to come anywhere close to current projections. The S&P 500 Index cannot report earnings growth in a recession! It does not happen. In a normal recession earnings decline on average 10% according to Bloomberg. Equity markets are not fully pricing in a recession, however, have priced in most of it with the S&P 500 Index declining to a low point that is 27% off its high. If Fed does not stop hiking after December’s hike, its ultra-restrictive monetary policy could push market into an earnings recession that should cause the S&P 500 Index to decline another 5-10% from current level. Keep in mind that the stock market bottom’s six months before earnings bottom. It will be time to buy stocks in the coming months.

Where does the market go from here in the short term? Investors may see a year-end rally given how oversold stocks have become, and extreme negative investor sentiment indicators. Every investor expects the stock market to drop further, which technically is a good rallying point. Historically in mid-term years, stocks bottomed out in October, then proceeded to produce above average returns in the next 12 months according to CFRA. Cyclical stocks outperform defensives after a Bear market bottom.

Beyond a year-end technical rally, markets are waiting for a moderation in inflation. The Fed wants to see inflation peaking over a three-month period before it becomes less hawkish. Historically, when inflation peaks the forward returns for the S&P 500 Index are positive according to Bloomberg research. A steady decline in inflation allows for earnings to meet expectation because consumers will then see their cost-of-living decline allowing for greater consumer spending. Consumer spending is the key to stock market valuations. Furthermore, profit margins should be higher if company input costs are lower. Lastly, lower inflation is key to higher consumer confidence. The path the stock market takes depends on the path of inflation.

Recent market volatility is very characteristic of a market bottoming process. Most Bear markets bottom in October – capitulation month. What is more, the average length of a Bear market, associated with a garden variety recession, is 11 months since 1929 according to S&P Capital IQ. This Bear market is going on its 11 month this November. It is too late to sell even if valuations adjust lower for the next six months. Instead, gradually invest in cyclical stocks which are in the long-term buy zone. The best values in stocks are created in a Bear market. Forward returns are among the highest from a Bear market low.

Economy

The U.S. is in the late-cycle expansion phase with high recession risks. The economy is contracting. U.S. economic growth disappointed through the first half of the year, with the average of Q1/Q2 growth contracting by 1.1%. A tight labor market makes it difficult to make a recession call. The contraction has not been deep enough to cause unemployment to rise by a few percentage points. A significant rise in unemployment is the telltale indicator of every recession. There is hope that any recession will be a mild and short lived because unemployment may only rise from today’s extremely low rate of 3.5% to 4.5% rate and not reach a 6% rate level characteristic of most recessions.

Conference Board’s Leading economic indicators have turned negative for the first time since the pandemic, pointing to a recession. Global PMI’s that measure manufacturing activity have contraction readings. Presently, Wall Street economists project real economic growth for 2023 at 1.1% according to Bloomberg. That is stall speed growth that could easily slip into a contraction.

For now, the U.S. economy is in its Late cycle phase characterized by Fed tightening financial conditions to curb inflation, tighter credit conditions, slowing sales and rising inventories, as well as downward earnings revisions. I would say at best the economy is experiencing Stagflation a term that means high inflation and low economic growth. Atlanta Fed’s GDP now model estimates real economic growth for the third quarter to be 2.8%.

The cost-of-living is running at its highest level in more than 40 years. It is too high for the Fed to stop hiking, and historically low unemployment provides the Fed cover to hike into year-end. The Fed believes there must be significant job layoffs to quelch inflation pressure. Wage growth is a contributor to inflation that must moderate for inflation to subside. Wage growth is beginning to moderate, 5.0% over the year ending September, however, it is still well above the average 3% rate associated with lower inflation expectations. Fed hikes aim to increase unemployment by at least one percent over the next twelve months thereby lowering wage hike pressure on business.

The Fed has a dual mandate of maximum employment and prices stability. Inflation is so hot that the Fed only cares about price stability now. Hence, the fastest rate hiking cycle in decades. A lot of tightening has already taken place and has not had time to really impact the economy. Monetary policy takes about six to nine months to work its way through the economy. The Fed will not know how much damage it’s doing to the economy until it happens. In other words, the Fed is driving the car looking through a rear-view mirror. Many inflation indicators are lagging indicators. What economists do know is that the rapid pace of tightening raises the risks of a more significant downturn in the economy. Most times, fast tightening cycles have led to recessions.

Wall Street inflation expectations are heading downwards with each successive rate hike. Economists expect the consumer price index to decline in 2023 as layoffs mount, wage growth slows, and consumer demand eases. I expect the Fed Funds rate to pause at 4.5% and then the Fed will prudently assess economic conditions. The Fed does not want to create financial instability, just price stability. Fed Funds rate at 4.6% is in line with the historical average. Add on Q.T. and its effectively 5.1% based on CME’s projected terminal value for FFR! In the past, the Fed stops tightening when the 10-years Treasury yield matches the Fed Funds Rate (FFR). Monetary policy has become so restrictive that it should create financial conditions that bring about lower inflation and employment.

What should an investor do at this point given the economy goes into a recession? A garden variety recession lasts about 10 months on average since 1950 according to Capital Group. Recessions are minor economic events when compared to expansions. The average economic contraction in a recession is 2.5% compared to a 24.6% rise in GDP output in a typical expansion that lasts 69 months. Equity markets lead the economic cycle by about seven months. Bear market’s bottom before a recession or halfway into one. The highest returns in the stock market occur immediately following a market bottom. Investors must own the same number of stocks they had going into a Bear market going out of one to recover unrealized short-term losses. Stay the course at this stage. Every Bear market is followed by a Bull market which starts in a recession or after declines we have seen already. In fact, by mid-recession stocks are rising in value again.

PORTFOLIO MANAGEMENT

The late-cycle economic phase with stagflation conditions and high recession risk calls for a balanced diversified portfolio. There-Is-No-Alternative-To-Stocks (TINA) is dead. Bonds for the first time in years are competitive with stocks. Although many stocks offer greater long-term growth potential. Stay balanced by overweighting quality short term bonds, and quality dividend growing stocks both defensive and cyclical ones.

Stagflation environments favors defensive sectors over cyclical sectors. Utilities, Consumer Staples, and Health Care have led the defensive leadership during periods of stagflation. Defensive sectors have outperformed cyclical sectors over the last 12 months. It is too late to overweight them in a portfolio. I would not add Utility or Consumer Staples stocks because of valuation concerns. Although, it is safe to own Healthcare stocks even as the economy slows down. Healthcare stocks are less economically sensitive and are still attractively valued. Also, rising dividends in healthcare stocks can counter inflation.

I am looking for opportunities in what has repriced for slower growth and even a recession. Most cyclical sectors such as Consumer Discretionary, and Technology sectors fit the bill. Twelve months from now I would expect those sectors to outperform defensives. Economically sensitive sectors lead the stock market into recession but also lead the stock market out of a recession. I am holding onto Technology stocks. Technology sector has produced positive returns during a recession when yields peak. I will add to Technology position when the two-year yields peaks, and the U.S. Dollar peaks. Technology stocks valuation repricing should soon be complete as interest rates are nearing a peak. A peak in yields should cause the U.S. Dollar to fall from its highs which benefits Technology earnings as a major part of sales are foreign.

Energy has underperformed during both stagflation and recession regimes; it is the most economically sensitive sector during recession. However, this time I believe its different due to supply issues, energy prices should hold up even in a U.S. recession. Energy companies are coming off record profits and free cash flow. Their balance sheets are healthy, and energy companies are returning capital in the form of dividend growth. Moreover, Energy sector is among the cheapest sectors. I am overweight energy and adding to position.

I am underweight foreign equities. Many foreign economies are projected to experience a more severe recession next year than the U.S. Higher energy cost abroad will squeeze foreign corporate profit margins. Given a stronger dollar, foreign equities earnings growth in the US dollar term has been downgraded, at some point earnings risk will be fully discounted into price. The dollar index hit its highest level in more than 20 years last quarter. The Fed has front loaded hikes at a pace not seen in decades. Interest rate differentials between countries makes the U.S. dollar more attractive compared to other currencies. However, the U.S. dollar could be peaking as interest rate differentials narrow going forward. That suggests adding foreign stocks in 2023.

I also want balance between equities and bonds. Bond returns after the Fed begins rate hikes in six of the past seven Federal Funds Rate hike cycles, generated positive returns 12 months after the Fed started to raise rates according to State Street Global Advisers. Furthermore, Late cycle to recession phase favors quality bonds over defensive stocks. Four to eight months before a recession, bond prices start to rise, especially long-term bond prices. What’s more long-term rates also reflect the outlook for growth and inflation. The more successful the Fed is in slowing the economy and inflation, the more likely it is that bond yields will stabilize or fall in 2023.

I also prefer quality bonds over defensive stocks because the yield curve is inverted right now which says economy is on a recession watch. Historically, in a severe economic slowdown, bonds outperform stocks. In a recession long term bond prices continue to rise providing a double digit return to investors according to FMR research.

High inflation in a maturing business cycle slipping into recession suggests buying only investment grade bonds. Downgrades in high yield security credit ratings is picking up this year according to Bloomberg. Financial conditions are tightening as High Yield credit spreads widen, downgrades increase, and default risk rises as the economy enters a recession. Most vulnerable bonds to default are non-investment grade bonds. Expect low quality bonds to underperform high quality bonds as economy slows. I have sold all non-investment grade bonds.

For now, I am overweighting short-term bonds, however, in coming months it should be time to overweight long term bonds. If CME forecast of 4.8% terminal FFR pans out, then I will begin adding more duration in portfolio by investing in long term quality bonds and cyclical stocks, instead of Treasury Bills in coming months. In the meantime, the case for putting money into short-term bonds is very compelling with 4% yields.