Key Take Away
For the last six months, investors have been highly focused on inflation slowing and an ensuing FED “pivot” (where they stop hiking and begin cutting rates) as a reason to buy stocks. As we’ve highlighted in previous writings, we don’t see it that way. We see recession risks rising and expect the FED to belatedly back off from their high-interest rate policy. Thus, portfolios remain very defensive relative to their benchmarks.
Inflation peaked in June and has been steadily easing while economic data has slowed; however, there has been no pivot by the FED. Instead, they have continued to increase rates, sticking with the game plan they laid out earlier this year…higher rates for longer. In December, we finally reached the point of the rate hiking cycle where the Fed downshifted to a 50 basis point rate hike rather than the 75 basis point hikes of the previous four meetings. This wasn’t the “PIVOT” the market was looking for. The Fed simply opted to dial down the incremental tightening pressure as they did not reduce the tightening. While some welcomed this development, the stock market has not rallied on the news (as it shouldn’t have). It seems that investor focus is beginning to shift from inflation to the potential 2023 global economic recession.
We expect inflation will continue to slow as the economy weakens and moves toward a recession. This will cause the FED to ultimately stop hiking rates (maybe within the next three to six months) as they pause to assess the situation. Eventually, they will be forced to reverse policy and begin cutting rates as the recession picks up steam. This is the most plausible scenario. Realistically, the FED will not begin cutting rates until economic data forces them to do so. At that point, rate cuts will not be bullish for stocks as economic gravity will have taken hold.
U.S. Outlook (Next 3-12 Months)
Overview
Despite hopes for a soft landing, the economic data continues to slow. Inflation was the primary concern of 2022. However, inflation peaked back in June and has been coming down steadily. It appears that a slowing economy and recession fears may become the risk on everyone’s radar for 2023 as we enter the next phase of this bear market.
The Fed has been focused on tightening interest rate policy to fight inflation all year. They were late to realize that inflation was a problem and have been determined to catch up and stamp it out. If they pivot from fighting inflation too early, they risk looking foolish again. Given this line of thinking, it has seemed to us they will be prone to do too much rather than not enough in the fight against inflation. Doing too much means the economy goes into recession. By raising interest rates and withdrawing liquidity from financial markets, the cost of money goes up. As a result, people spend less, the economy slows, and corporate profits go down. Inflation also goes down when the economy slows; in fact, we’ve never had a recession that didn’t bring down inflation (over the short to medium-term). But inflation is yesterday’s news. The consumer has been pinched by inflation and is tightening the belt. Gridlock in congress will likely mean less fiscal spending over the next two years. Plus, the FED continues to hit the brakes with higher interest rates. Meanwhile, stock prices remain historically elevated relative to their expected forward earnings. As the economy slows, gravity should set in and pull stock prices down.
While we continue to expect stock prices to go lower in the coming months, we also believe bond yields will decline. Remember, when bond yields drop, bond prices go up. Bonds prices were positively correlated to stock prices for much of 2022; this is unusual as they were declining side by side. Thanks to this breakdown in correlations, 2022 has been an exceptionally awful year for many investors. However, over the last 40 years, bond prices are typically negatively correlated with stocks. In other words, most of the time, when the stock market experiences the type of decline we saw in 2022, a diversified portfolio would have received some relief from long-term bonds (especially long-term treasury bonds).
For the next phase of this bear market, it appears bonds and stocks are returning to a more traditional negative correlation. Over the last month, we have seen bonds behave as they usually do when economic uncertainty builds…stock prices go down while bond prices go up. Given this development, we’ve begun adding long and intermediate-term treasury bonds back into the models. In this environment, we believe long-term treasury bonds become a protection for the portfolio.
Model Positioning
LHWM model portfolios remain defensive. Short-term treasury notes continue to offer an attractive yield, and we have continued to add to that positioning. We have increased allocation to these notes to 25% in most LHWM model portfolios with room to add more. Long-term treasury bonds (10-30yr maturities) have started to behave as they usually do in a slowing economic environment. With that said, we have begun gradually adding this exposure back into portfolios. The small amount of stock exposure in all models focuses on defensive sectors. We have also added gold and precious metals exposures back into the mix. We anticipate that market volatility will continue in 2023. Keep in mind that we will adjust the amount of stock exposure and short exposures based on short-term market fluctuations to risk manage the volatility. Market risk remains elevated, so we have continued to keep risk exposure limited.
Keys to the Market
Chicago PMI – As we have highlighted before, PMI (Purchasing Managers’ Index) is a leading economic indicator designed to show the health of the manufacturing sector. Manufacturing strength or weakness tends to lead the rest of the economy. PMI is a diffusion index; above 50 indicates economic expansion, and below 50 indicates contraction. Chicago Area PMI has been declining all year and recently fell sharply into contraction territory with a November reading of 37.2. Yikes! While this is only one of the six other regional PMI indicators, the Chicago Fed PMI level is alarming. Over the last 50 years, the U.S. has fallen into an official NBER recession every time the Chicago PMI has dropped below 40.
Continuing Claims – This is a measure of ongoing unemployment. The chart below illustrates the change in continuous claims versus the one-year low to identify statistically significant upticks in ongoing unemployment. We have recently seen continuous claims tick up by 0.28% above the one-year low. Over the past 50 years, when claims have increased by over 0.28% above the 12-month low, it has occurred due to a recession. We’ll see where unemployment goes from here, but many indicators (including the FED forecast) are signaling more job losses ahead.
Home Prices vs Mortgage Rates – The black line is measuring the 30-year mortgage rate (shown in the left margin of the chart). The blue line measures month-over-month home price changes based on a 20-city composite index (shown in the right margin). The U.S. has just experienced the fastest increase in mortgage rates in history. Home prices have already begun to fall in response. If mortgage rates remain elevated and jobless claims continue to rise, home prices should continue to fall. Housing tends to be a significant leading indicator for the broad economy.
Remember, bear markets and recessions take time to unfold. Patience is key. With recession risk elevated, it is wise to invest conservatively for a while. The stability of a conservative allocation is what will afford us the opportunity to buy investments if/when they go on sale due to economic gravity pulling down equity prices. We remain conservatively positioned in all models and vigilant in navigating these uncertain markets. During the course of our relationship, we have worked with you to establish a portfolio that matches your financial planning needs, risk tolerance, and investment timeline. With that said, it’s critical to remain patiently invested in the appropriate model. Stick to the plan!
Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review.
Sincerely,
Lake Hills Wealth Management