Key Take Away
With two consecutive quarters (Q1 and Q2 2022) of negative Real US GDP growth now official, the debate has begun over whether the US economy is in recession. While two consecutive quarters of negative GDP growth has long been a generally accepted definition by many, the NBER (National Bureau of Economic Research) has a broader definition. They look for contractions in industrial production, nonfarm payrolls, real personal consumption, and real income, among others. While these factors are not negative at this point, all are trending lower. We would also like to point out that looking at data going back to the 1940s, every time the U.S. experienced two consecutive quarters of negative GDP, we eventually went into an NBER-defined recession with the one exception in 1947. However, in 1948, the U.S. did go into an NBER-defined recession, so we’d say the odds are high that we will enter a real recession soon. Rather than focusing on textbook definitions, it is noteworthy that there is little argument on whether economic growth is slowing…this is evident in the data. With that said, LHWM models have remained defensively positioned since February. Source: Bloomberg
U.S. Outlook
Overview
Rather than focusing on the definition of recession, the better question is: Where are the markets headed from here? To that point, the rally in the stock market over the past couple of months has prompted many to wonder if the “bottom” is in for this bear market. While it is true that the stock market typically bottoms prior to the end of a recession, we do not believe we are there yet. In fact, it appears more likely this economic malaise could drag on for the next several quarters based on leading economic data, and based on our research, the actual recession is forecasted to come in the first half of 2023. The latest indicator that we’d like to highlight is housing.
Housing is a crucial leading indicator with a strong track record of predicting economic contractions and expansions. With home prices up 42.82% from March 31, 2020, coupled with the recent rise in mortgage rates, housing affordability has plummeted to levels not seen since 2006 (the peak of the last housing boom, per Bloomberg). As a result, we’ve seen a dramatic slowdown in new home sales volumes over the last six months. The housing sector, being very sensitive to interest rate changes, tends to move before the broader economy. When rates increase, it significantly impacts mortgage payment affordability. Additionally, the purchase and maintenance of a home are large budget items…economic uncertainty also causes people to delay buying or trading up to a more expensive house. A slowdown in the volume of home sales has many knock-on effects on the economy. The purchase of a home generally leads to spending in other areas such as retail sales (appliances, furniture, and other home furnishings), bank fees (mortgage financing), along with other construction and renovation expenses. Thus, it is easy to see why the housing sector often leads the economy in and out of recession. Source: Bloomberg
The Fed continues to fight inflation by increasing interest rates and by removing liquidity from financial markets through QT (Quantitative Tightening). At the end of July, the FED hiked the FED Funds rate by another 75 basis points, bringing the rate from 0% up to 2.25% since March. This has contributed to rates re-pricing higher across the yield curve since the start of the year. The average 30-year mortgage rate (Bankrate Average 30-year mortgage rate) in the U.S. topped 6.0% in June, up from 3.27% at the end of 2021. As a result, new home sales volumes have already slowed significantly. The full effects of rate hikes take time to show up in the broader economy with long and variable lagging effects of 6 to 12 months...the first quarter-point rate hike was in March, just over four months ago. The Fed has now implemented nine quarter-point rate hikes in 4 months. With very little time having passed since March, the full impact of these hikes have not yet been felt by the economy. A more normal rate hiking cycle would take two years to conduct the number of rate hikes that have been implemented over the last four months. The Fed will also be ramping up QT in September as they allow over $95 Billion per month ($60B in Treasury Bonds & $35B in Agency Debt) to mature off or outright sell. Previously, maturing proceeds would be used to buy new bonds. The net effect is there will be $95 Billion per month of liquidity removed from markets. When dollar liquidity is removed from markets, this puts additional negative pressure on borrowing costs and asset prices. Source: Bloomberg
The Bottom Line
FED policy remains restrictive, with additional rate hikes planned for the coming months. This is negative for the economy and thus the stock market. An old adage of the investment community is “don’t fight the Fed.” In other words, it is unwise to position your portfolio for an outcome that is against the Fed’s target. Their policy tools are very powerful, and they generally produce their desired outcome. They remain focused on slowing the economy to fight inflation which currently stands at an eyepopping 8.5% year-over-year rate (Headline Consumer Price Index). As far as we can tell, they are well on their way to achieving this goal…Source: Bloomberg
Model Positioning
LHWM model portfolios have remained defensive since our July update. The most significant change to portfolio positioning over the past month has been the re-introduction of long-duration government treasury bonds. We’ve started adding this position back in the model portfolios after being stopped out in June. These long-term bonds have recently broken their downtrend and appear to have begun new uptrends. As recession risks rise and inflation pressures ease, this opens the door to a rebound in treasury bonds during the second half of the year. While we believe this to be the most likely outcome for bonds, we intend to take our time rebuilding this position as we seek market-driven buying opportunities (scaling into the position on dips). Model stock exposures have been virtually unchanged since July and continue to be entirely focused on defensive positions (utilities, high-dividend stocks, & consumer staples). Similarly, allocations to hedged positions remain in place (these do well when the stock market drops). Ultimately, LHWM models continue to be positioned to have a low impact from movements in the stock market.
Keys to the Market
New Home Sales – As mentioned in the overview section, housing is a leading indicator of economic growth. The chart below depicts new home sales since 1965 and highlights the eight recessions (in red) that have occurred in the U.S. Every recession, except for the 2000 dot-com bust and the 2020 covid recession, was preceded by a significant decline in new home sales of 40% or more. On the flip side, an uptick in new home sales often leads the economy out of recession. Since the post covid peak, we have now seen a decline of 43% in new home sales. Source: Bloomberg
*Red shaded areas indicate NBER defined U.S. Recession
Bear Market Rallies – With many leading economic indicators pointing to weakness, one might wonder why the stock market has rallied over the last few weeks… Well, big rallies over short periods of time are actually a hallmark of bear markets. A typical bear market can last 18 to 24 months with significant volatility along the way. The S&P 500 recently peaked on January 3rd, so we are little more than seven months into this bear market. The chart below illustrates the performance of the Nasdaq during the dot-com bear market. Notice (chart below) the four momentous rallies that occurred over the two-year 82.9% decline in price. We aren’t implying that the current market will experience a decline of this magnitude, but rather we are pointing out that significant rallies often occur during periods of bear market declines. Source: Bloomberg
S&P 500 Earnings – Post-Covid, S&P 500 companies experienced a profit boom fueled by stimulus, which helped to propel the stock market to new highs in 2021. The following chart depicts forward earnings per share of the S&P 500. Notice the sharp increase as earnings moved well above trend (the middle line of the five lines is the 30-year trend) during 2021, and expectations remain high for 2022. If earnings were to revert to trend, it would imply an earnings decline of approximately 25%. It is worth pointing out that during a U.S. recession, earnings usually decline by an average of 20%. A significant decline in earnings would likely cause another leg down for the stock market. Source: Bloomberg
*Red shaded areas indicate NBER defined U.S. Recession
Bear markets and recessions take time to unfold as economic data and market prices can diverge. Currently, we don’t have any economic indicators that support the current rally in the stock market, and we reiterate our recession call over the next 12 months. The most difficult aspect of a bear market is to remain defensive when stock prices continue higher. After all, fear and greed are powerful forces that move markets, regardless if the moves are fundamentally driven.
Vigilance and patience are key as this eventual downturn will bring great opportunities. We have worked with you to establish a portfolio that matches your financial planning needs, risk tolerance, and investment timeline. As always, it’s critical to stay invested in the appropriate model and 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