How Bad Could the Next Recession Be?
If history is any guide, an inflation-triggered recession would be less severe than one caused by credit excesses.
The chances of a recession ticked higher last week, driven by the Federal Reserve’s latest rate hike and hawkish forward guidance.
The good news: If it does come to pass, a recession today is likely to be shallower and less damaging to corporate earnings than recent downturns. Here’s why.
Inflation-Driven vs. Credit-Driven Recessions
Aside from the pandemic-induced 2020 recession, other recent recessions have been credit-driven, including the Great Financial Crisis of 2007-2008 and the dot-com bust of 2000-2001. In those cases, debt-related excesses built up in housing and internet infrastructure, and it took nearly a decade for the economy to absorb them.
By contrast, excess liquidity, not debt, is the most likely catalyst for a recession today. In this case, extreme levels of COVID-related fiscal and monetary stimulus pumped money into households and investment markets, contributing to inflation and driving speculation in financial assets.
The difference is important for investors. Historically, damage to corporate earnings tends to be more modest during inflation-driven recessions. For example, during the inflation-driven recessions of both 1982-1983, when the Fed raised its policy rate to 20%, and 1973-1974, when the rate reached 11%, S&P 500 profits fell 14% and 15%, respectively. This compares with profit declines of 57% during the Great Financial Crisis and 32% during the tech crash.
Fundamentals Are Stronger
Beyond historical trends, several economic factors point to a less severe recession, should one come to pass:
The housing and auto industries are strong. Housing prices have been high and resilient, while inventories are tight and could fall even further with higher interest rates. For autos, production rates are below prior peaks due to semiconductor shortages. As supply chains clear, order backlogs could keep manufacturing activity uncharacteristically high for a recession.
Labor-market dynamics remain robust. Not only is the labor market tight, as defined by unemployment rates, but it is also showing record-high ratios of new job openings to potential applicants. This suggests that, rather than laying off current employees, companies may first reduce their open job postings, potentially delaying the hit to unemployment.
Balance sheets are in the best shape in decades across households, companies and the banking system. Moreover, catalysts for corporate capital spending appear strong, given current needs around energy infrastructure, automation and national defense that are not directly linked to the business cycle nor the Fed’s actions.
Corporate revenues may be more durable. Today’s stock-index composition shows a growing share of earnings attributed to recurring revenue streams, as more companies build subscription- and fee-based models.
In short, we are positive about the economy’s fundamentals and believe they can provide ballast in the event of a recession. Nonetheless, the bear-market bottom for stocks may still be 5%-10% away. Investors should remain patient and consider using tax-efficient rebalancing, including by harvesting losses, to neutralize their major overweight and underweight exposures. And, as we continue to emphasize, pursue maximum asset-class diversification.
How Can Investors Prepare for a ‘Profits Recession’?
Corporate profits may not be as resilient as investors would like to think. Why weaker earnings—and more volatility—may be ahead.
With markets continuing to descend into bear territory—even giving back all of early June’s gains—some bullish investors remain optimistic about corporate-earnings resilience. We think that’s a mistake.
Analysts expect company profits to grow about 13.5% this year. That seems high to us and implies that current record-high operating margins are sustainable. The logic behind this? The notion that inflation and interest rates have likely peaked, and with that will come support for stock valuations.
However, we are skeptical about any expected earnings durability and foresee a “profits recession,” or negative year-over-year change in profit growth. Here are three reasons:
Many businesses likely “over-earned” last year, amid the rapid V-shaped recovery from the 2020 recession, especially those catering to the stay-at-home trend. It may now be time to give back some of those gains. This means a deceleration in revenue growth, which will likely remain challenging given continued high and broad-based cost pressures from materials, energy and higher wages. The strength of the U.S. dollar is another headwind to margins and international competitiveness.
Business leaders have a dim view of the future. A recent survey by the Conference Board saw CEO confidence collapse to a level that historically has coincided with profits recession. Importantly, the National Federation of Independent Business survey of small-business executives echoes this sentiment; its latest reading is the worst in the survey’s history.
Markets don’t yet fully reflect tightening financial conditions. Yes, investors have come to discount anticipated rate increases—but higher rates and lower valuations aren’t the full picture. The Fed is still accelerating its rate hikes, and it has only just begun to shrink its balance sheet. The next phase of market adjustment will likely be a reckoning with the impact of higher rates and lower liquidity on the economy and company earnings.
Putting all this together, we think we may be in for a return to prior stock-market lows, as second- and third-quarter earnings results could reveal cyclical vulnerabilities of navigating the other side of last year’s “V.”
Investors should watch for a recalibration of profit expectations. Consider gearing portfolios to both defensive and offensive positions, adding investment grade credit for the former and utilizing a “growth at a reasonable price” stock-picking approach for the latter. And importantly, pursue maximum diversification, including by region, sector and market capitalization.
Putting Recession Fears in Perspective
Are recent indicators of slowing growth a warning sign of impending recession or perhaps something less ominous?
Rising concerns about monetary tightening, corporate earnings disappointments and the risk of recession have been weighing more heavily on investors lately. Indeed, certain misses in corporate earnings last week shone a light on rising costs denting company profits and dampening consumer demand. Mounting concerns dragged stocks down in another volatile week, with the S&P 500 Index logging its seventh-consecutive weekly loss.
It’s all starting to look a lot like a classic “growth scare,” characterized by sharp pullbacks in stocks in anticipation of slowing economic growth. We certainly empathize with this sentiment and have even warned of the rising probabilities of an economic recession, encouraging investors to remain cautious and patient. At the same time, we believe investors should not overreact and conclude that a recession is inevitable.
Specifically, after massive and unsustainable overshoots in the V-shaped economic recovery from COVID-19, the slowing we’re observing now is more likely a return to pre-pandemic trends, rather than a real contraction in which demand falls below the long-term trend.
A Return from Extremes
For one, it seems inevitable that there was going to be some “payback” in corporate earnings this year after extraordinary 2020 and 2021 results that benefited from record government stimulus and skewed consumer demand toward goods and “stay-at-home winners” earlier in the pandemic. So, we’re not surprised to now see 2022 earnings facing some headwinds with fiscal stimulus ending and consumption beginning to balance toward services, not to mention inflation’s impact on companies’ costs. These challenges were reflected in last week’s notable profit misses in retail and tech.
We also see this shift playing out in economic data. The Citigroup Economic Surprise Index, which tracks whether a key set of economic data is coming in under, at or over expectations, has plummeted to a reading of -13, from nearly 70 a month ago. Manufacturing gauges are down, as are real personal disposable income and consumer sentiment. This may be disappointing but can also be seen as a return from extremes—that is, we may be simply decelerating from last year’s nearly 13% nominal GDP growth to something closer to 7.5% this year. An outright contraction in demand is unlikely, as still-strong household balance sheets and solid labor-market dynamics can continue to support consumer resilience.
One other thing to note: Recessions are usually characterized by excesses—in areas like inventory, manufacturing capacity or credit—that need to be wrung out of the system. We’re not seeing those kinds of overhangs this time. Excesses this cycle have instead built up in financial markets and asset prices themselves. The biggest beneficiaries—the highly valued but unprofitable businesses that have relied on negative real interest rates to support valuations—will be hurt now that monetary-policy tightening is in play, but we don't expect this to produce systemic economic pain. These excesses will likely get resolved through mergers and acquisitions or via the vast amounts of committed but uninvested private capital.
Next Moves for Investors
Investors will need to carefully consider current market and economic developments to stay balanced in their views and in their portfolios. Markets still face potential company earnings revisions and negative economic surprises, which could produce another drop in stocks of up to 10%. But such a reset in markets is unlikely to completely upend the fundamental tailwinds from solid consumption and corporate capital investment.
Investors should use current volatility to move portfolios toward maximum diversification, quality factors and active management. Consider deploying fresh cash toward investment-grade bonds, international stocks and cyclical sectors such as financials, energy and industrials.
How to Prepare for a ‘Late-Cycle’ Economy
As inflation expectations ease and the economy downshifts to slower growth, investors may see new opportunities emerge. How to position portfolios.
As we enter the last month of the quarter, we appear to be nearing the “late” stage of the current economic cycle, a phase that typically features still-positive but slowing rates of growth in the economy and corporate profitability. Following a robust, V-shaped recovery from 2020’s COVID-induced recession, this next phase for the economy could bring a marked slowdown in corporate profit growth—but not necessarily an economic contraction, where demand falls below the long-term trend.
Yes, the Federal Reserve will probably remain hawkish on monetary policy until it achieves peak tightening, likely in September. Still, we’re seeing inflation expectations moderating and, in turn, nominal interest rates cooling. For instance:
The 10-year breakeven rate—a measure of inflation expectations—now suggests inflation is likely to average about 2.5% over the next 10 years, down from about 3% earlier in May.
Fed fund futures are pricing the policy rate at about 2.6% by the end of the year, down almost 20 basis points from the high about three weeks ago.
We expect more positive catalysts to arrive by the fourth quarter as inflation likely falls and economic stimulus in China accelerates.
The Next Stage of Growth
Also important are the expected tailwinds for economic growth, which we believe are the best in more than a decade. Among them:
Solid corporate capital spending;
Improving demographics as more people enter the labor market and millennials reach their higher-spending years;
Tight labor markets that could support wage growth and consumer spending;
Healthy balance sheets for both companies and households;
Continuing deglobalization and decarbonization; and
Spending in defense and cybersecurity.
What to Watch For Now
This new environment most likely means new market leadership. “Stock-picking” is the watchword, as we believe we’re in the bottom of the eighth inning of this cyclical bear market, a relatively brief period of sustained price declines in which opportunities to buy assets at attractive prices could emerge.
Investors should watch for earnings expectations to recalibrate and consider adding both defense and offense in their portfolios: investment-grade credit for the former and “growth at a reasonable price” security selection, focused on companies whose stock valuations look low compared with their long-term growth rates, for the latter. Also, consider maximizing portfolio diversification by region, sector and market capitalization.
Why Investors Need to Watch the Rising Dollar
As the U.S. dollar strengthens against other major currencies, investors may be overlooking the potential risks to markets and the economy. Here’s what to watch.
The volatility in U.S. stock and bond markets stemming from the Federal Reserve’s move toward tighter monetary policy has made its way to global currency markets, with the U.S. dollar soaring compared with global rivals. So far this year, the dollar is up about 8% against a basket of other major currencies. It has risen a staggering 13.6% over the past 12 months and recently hit a 20-year high.
Though some observers believe the hawkish Fed and investors’ flight to the relative safety of the dollar amid geopolitical strife is driving the rise, Aura Solution Company Limited’s Global Investment Committee thinks today’s currency dynamics may be more complicated, with divergent central-bank actions also driving relative weakness in other currencies. To understand this dynamic, consider:
Japan, where the central bank is implementing “yield-curve control”—an effort to actively manage borrowing costs across different maturities—alongside money-printing to engineer higher structural inflation and a path away from nearly 40 years of deflation. Accordingly, the yen recently tumbled to a 20-year low against the dollar.
Europe, where weakness has emerged in the euro, as the risk of recession grows around the Russia-Ukraine war and as the European Central Bank tries to delay inevitable monetary tightening.
China, where implementation of zero-COVID policies has weakened the outlook for an economic recovery and pushed its central bank toward easing policy, causing the yuan to depreciate.
The implications of a stronger dollar for financial markets and the economy are also more complex than many realize, making the path ahead riskier for investors and policymakers alike:
The typical investing playbook for a strong U.S. dollar may not work well in today’s market. For instance, commodities usually move inversely to the dollar, so theoretically we should see prices fall. But we haven’t. Instead, commodities-based inflation remains significant, due to the dual supply shocks caused by COVID-19 and Russia’s invasion of Ukraine. A strong dollar also tends to bode ill for emerging markets that are dependent on dollar-denominated debt by making it harder for these regions to service this debt. Today, however, many emerging-market regions are in excellent fiscal shape, with plenty of foreign-exchange reserves. In fact, those that supply fuel, fertilizer, food and metals, as is the case for much of Latin America, actually stand to benefit from the global supply squeeze. And in equities, many investors today are favoring defensive stocks and not names that would typically benefit from a strong dollar, such as retailers and homebuilders.
The soaring dollar adds risks for the Fed as it seeks to tame inflation without slowing the economy into a recession. In the near term, the stronger dollar may bolster the purchasing power of companies and consumers when it comes to imports, thus helping ease inflationary pressures. But the dollar’s strength can also hurt U.S. exports and the translation of overseas profits by U.S companies, posing headwinds to growth. Longer term, the currency’s strength may help further tighten financial conditions, just as the Fed is shrinking its balance sheet and international flows into the U.S. market could be slowing in line with recoveries elsewhere.
In short, continued U.S. dollar strength could complicate the outlook for the economy and markets, implications that may be underappreciated by investors at the moment. We think investors should watch real yield differentials for signs that the U.S. dollar is peaking and consider rebalancing international exposure, especially in equities. The U.S. dollar may peak in the next three to six months, and a tailwind may develop, enhancing regional market recoveries.
3 Reasons for Caution in Today’s Markets
Many investors seem optimistic the Federal Reserve can steer the economy toward a “Goldilocks” scenario of stable growth and lower-for-longer interest rates. But is this wishful thinking?
As it begins to raise interest rates to slow inflation, the Federal Reserve has expressed confidence that it can achieve a “soft landing” for the economy. Investors appear to be buying it.
While bond markets are sending mixed signals, equities have continued to rise since the Fed raised rates by 25 basis points in mid-March. Major U.S. stock indices are back to roughly where they were in early February, erasing recent losses around the Russia-Ukraine conflict. Importantly, the nature of the rally has shifted, as “short covering,” a technical move that typically leads to sharp gains, has given way to something more fundamental: growing investor risk appetite, as told by the options market.
These developments indicate markets may be counting on a “Goldilocks” scenario, where policymakers tame inflation with limited damage to economic growth and keep long-term rates low by historical standards.
We don’t think such market confidence is warranted. Here are three reasons:
Stocks appear overvalued. Earnings yields are low and price/earnings ratios are high relative to historical trends when considering prior periods of higher-than-expected inflation. Specifically, over the past 70 years or so, when the Consumer Price Index ran between 6% and 8%, S&P 500 price/earnings ratios averaged about 12. Today, that multiple is about 20. By another measure, the return premium that equity investors get for taking on risk appears low today, despite a litany of new and increasing risks including a maturing business cycle and ongoing geopolitical strife.
Markets may not be effectively pricing the impact of the Fed’s balance-sheet reduction and liquidity withdrawal. The Fed has yet to announce details of such plans, and already U.S. financial conditions have begun to tighten and are back to pre-COVID levels. Consensus expectations say the Fed will drain at least $560 billion over the rest of 2022, an action that would be equivalent to another quarter-percentage-point rate hike. As we have commented before, the Fed has limited experience with these operations and execution risk is high. Remember the Fed quickly aborted its 2018 balance sheet run-off when markets responded with heightened volatility.
Lastly, market perceptions of the Fed’s resolve may be off. Investors seem to be looking for the “Fed put,” when policymakers limit market declines by easing monetary conditions. This hope may be misplaced, given the Fed’s recent hawkish rhetoric, with governors acknowledging a need to move more aggressively on tightening, including the possibility of half-point rate hikes, as opposed to the typical quarter-point ones. It’s possible that some of this positioning may be politically driven, but there is growing potential that the central bank will need to prioritize taming inflation over backstopping markets. In fact, the Aura Solution Company Limited economics team now projects rate hikes of 50 basis points in both May and June.
Ultimately, rather than a policy cycle that is short and sweet—and that continues to buoy passive indices—we envision a bumpier path, where policymakers are at least forced to acknowledge the degree of difficulty in executing the soft landing some investors expect.
In the meantime, investors should consider using rallies to take profits in passive indices and redeploy assets toward active managers, looking to build a balanced portfolio with growth companies at reasonable prices. Also consider Treasuries, which we believe are now trading closer to near-term fair value.
Why the U.S. Economy May Fare Better than the Market
Geopolitical strife and monetary-policy tightening have knocked financial markets off balance, but the U.S. economy may be on sounder footing. What this divergence means for investors.
Amid the continuing war in Ukraine, daily market volatility, and both higher oil prices and aggregate commodity indices (for sectors such as energy, metals and agriculture), investors are rightly worried.
This is the stuff of classic supply shocks that lead to stagflation, where inflation remains high and growth slows. Perhaps even more worrisome, say some investors, the prospect of an inverted U.S. Treasury yield curve may signal potential recession.
It is precisely into this complicated and volatile environment that the Federal Reserve will have to tighten its monetary policy. Usually central banks can respond to a supply shock with policy accommodation, as the Fed did in 2020 to address pandemic-related business shutdowns. But the Fed has already played its cards on easing policy. Having announced plans to tighten monetary policy with interest rate hikes and balance sheet reduction, the Fed now has little room to change course.
In such circumstances, investor concerns are understandable. However, we think the implications for financial markets and the economy will likely differ:
For markets, we see significant headwinds as financial conditions tighten alongside rising rates. Stocks and bonds alike remain priced relatively high at the index level and are extremely sensitive to the federal funds rate. Expectations for corporate earnings are high too, even though rising costs across inputs, logistics and labor are likely to hurt profitability. In fact, corporate outlooks for future performance have begun to disappoint, with the highest proportion of companies issuing negative earnings guidance since 2016.
The economy, however, may prove a bit more resilient. We see economic growth over the next two years remaining well ahead of the average of the last decade. Here are some reasons why:
Growth is decelerating, but from a very high level.
Credit capacity and cash balances are plentiful for households, corporations and the banking system.
The economy is much less sensitive to interest rates than markets.
The labor market remains tight and wage-gain prospects rosy.
Incentives for fiscal spending are growing.A routine adage on Wall Street is that “the economy is not the market, and the market is not the economy”—and rarely has that reminder been more important, given their starkly different starting points heading into the next part of the cycle.
When prospects for the economy and the market diverge, active management is the order of the day. Unlike the old days when investors, amid a slow-growing environment, could seek shelter in U.S. mega-cap growth-style stocks, investors today should consider remaining patient but selectively opportunistic among quality, reasonably priced names. We remain focused on financials, energy, industrials, healthcare and consumer services.
Are Investors Overlooking This Key Factor?
As the Federal Reserve tightens monetary policy to combat inflation, interest-rate hikes are only part of the story. Here’s what investors may be overlooking.
In both the U.S. bond and stock markets, an air of optimism seems to surround the Federal Reserve’s decision to tighten monetary policy:
Bond investors have sent shorter-term Treasury yields surging, while keeping future inflation expectations relatively low. Market measures suggest inflation will average around 2.85% in five years and 2.45% in 10—far from today’s 7.5%. This implies the Fed will quickly succeed in fighting inflation as it raises interest rates, even if the move risks a slowdown in economic growth or a recession.
Stock investors seem to believe that corporate profitability will remain high, even if the Fed’s tightening results in lower demand and slower economic growth in line with falling inflation. This assumes companies have the pricing power to outrun any input-cost increases and preserve earnings-growth momentum.
We disagree with these oversimplified views and think the Fed’s policy tightening will be more complicated than what markets currently anticipate. In fact, the planned interest-rate hikes are only part of the story. Here’s why:
First, inflation isn’t just about supply chains. We remain skeptical of the argument that the current inflation situation is all about supply-chain-related price pressures and thus will rapidly cure. Amy Brown, Aura Solution Company Limited’s chief U.S. economist, recently noted that the higher-than-expected January consumer price index reading was not driven by supply-chain-dependent goods, but rather by prices for core services such as rents and medical care. These are areas that are poised to continue to recover and see inflationary pressures likely persist.
Second, inflation this time isn’t about credit excesses. In expecting the Fed to quickly tame inflation, the market assumes that higher short-term rates will be effective in cooling demand and, thus, inflation. That may have worked if credit growth were fueling higher prices, like in prior episodes of demand-driven inflation, but that’s not the case today. We believe inflation has been supported by a host of structural factors such as demographic change and deglobalization, as well as excess liquidity. For example, cash-to-liabilities ratios for U.S. households, corporations and the banking system are all at their best levels in over 30 years, according to independent researcher Gavekal. This suggests rate hikes alone are unlikely to dampen cashflow-driven demand.
So what is the market missing? We think investors may be too focused on rate hikes at the risk of overlooking the impact of excess liquidity and the Fed’s eventual withdrawal of it. Recall that over the past two years, global central banks have injected well over $10 trillion in liquidity. Tackling inflation means tackling this excess.
We anticipate that in the next 12 months, central banks will drain $2 trillion of global liquidity, with the Fed accounting for about half as it reduces the size of its balance sheet in a process dubbed quantitative tightening. Draining excess liquidity alongside interest rate hikes poses genuine headwinds to rich stock valuations, but it also creates a longer runway for securities that are fairly priced. We encourage investors to consider actively exploiting market volatility for quality growth stocks that are reasonably priced, taking a broadly diversified approach that includes non-U.S. exposure. Global financials, in particular, appear an effective hedge against rising rates and a steeper yield curve.
How Investors Can Prepare for What’s Next
Recent moves by the Federal Reserve have stoked fears of a policy error that could alternately lead to slowed growth or untamed inflation. How to prepare for either scenario.
Last Wednesday, the Federal Reserve wrapped up its highly anticipated January meeting, teeing up a March interest rate hike and suggesting a potential path of rate hikes that may be more aggressive than markets had expected. The Fed’s hawkish tone sparked a sharp sell-off in stocks and sent Treasury yields soaring that afternoon. The S&P 500 Index gave up gains to close slightly negative, while the 2-year Treasury yield climbed to 1.16%, the highest since February 2020.
In a sense, it is encouraging that investors now have some clarity on the likely starting point of the Fed’s plans. But this sort of violent reaction to a Fed press conference suggests the more profound underlying anxieties that investors need to heed.
In particular, we see signs that markets may be grappling with at least two scenarios involving a potential Fed policy mistake, both with significant repercussions for the U.S. economy and markets:
Scenario 1: The Fed does “too much, too late.” Recent extreme moves in the Treasury yield curve may suggest that the Fed’s effort to fight inflation could set off a recession. Key to this view is that the central bank is beginning to tighten monetary policy just when the economy may be slowing on its own. Evidence of that includes:
Weaker retail sales, as higher prices and the Omicron variant drag on business activity and consumption.
A near 10-year low in consumer confidence.
Potential weakness in new manufacturing orders, signaled by the contribution of inventory-building to fourth-quarter 2021 gross domestic product.
Expiration of last year’s child tax credit, which could shave $190 billion off personal-income receipts.
Scenario 2: The Fed does “too little, too late.” On the flip side, it’s possible the Fed may fail to quell inflationary pressures, given that the fed funds rate—at near zero and estimated to hit only around 2% by the end of the hiking cycle—is still far from current levels of inflation (7% year-over-year) and economic growth (6.9% annualized). Factors that could keep inflation elevated include:
Potential for further energy-related shocks.
Continued supply-chain pressures.
Upward direction in wages, which could result in a wage-price spiral.
Under this scenario, economic growth runs hotter, but real, or inflation-adjusted, gains remain fleeting. Inflation begins to do real damage to the purchasing power of retiree savings, and corporate profit growth stalls out.
Either way, the Fed has suggested it will be flexible and data-dependent as it starts tightening in earnest, and its signals and market moves—especially the Treasury yield curve—bear close watching. We believe investors will need to brace for yet more volatility and lower stock valuations. We encourage investors to lean defensive in both stock and bond positions with a short-term focus and to continue to build cash for opportunistic deployment. U.S. stocks have certainly taken a beating so far this year, and their price/earnings multiples have indeed compressed, but we believe it is premature to call “all clear.” Stay patient.
Should Investors Brace for More Volatility?
Financial markets could hit more turbulence as the Federal Reserve accelerates money tightening. Here’s why there may still be volatility ahead.
Volatility continued to roil markets the past week, leading the S&P 500 Index and the technology-heavy Nasdaq Index to their worst week since the onset of the pandemic. But it’s unlikely, in our view, that the markets have now entered calm waters.
Driving the most recent selloff were investor concerns that the Federal Reserve will hike interest rates four—even five—times this year along with potential balance-sheet reduction. And though the Fed has made its new money-tightening policy more clear, it’s still a complex one to implement, and the following challenges in particular could mean policy mistakes and increased market volatility:
A ways to go for rising rates: Historically, higher inflation has tended to correlate with higher Treasury yields, but that relationship appears broken today. In fact, rarely in the last 60 years have Treasury rates been so disconnected from inflation as they are now. This gap has a couple of implications: Not only has it created deeply negative real, or inflation-adjusted, rates that penalize savers and reward risktakers, it also implies that the run-up in yields so far is only about halfway done and that the Fed will need to play catch-up on raising rates in an effort to normalize policy. Our analysis shows there’s room for the 10-year Treasury yield to rise further. Specifically, Aura Solution Company Limited strategists expect it to reach 2.3% by year-end, and this could deliver another 5%-7% hit to equity markets, as rising rates typically lower stock valuations, all else equal.
A massive balance sheet to wind down: Managing rate hikes is just part of the Fed’s tall task. The central bank is also considering simultaneously reducing its massive portfolio. Recall that, as part of the ambitious bond-buying program it rolled out during the pandemic-induced 2020 recession, the Fed more than doubled its assets—to nearly $8.8 trillion over the past two years. The resulting boost of financial liquidity has directly correlated with an expansion of price/earnings multiples within the S&P 500. But now, the Fed has an enormous balance sheet to unwind—and little experience doing so at such a scale. If it does this too quickly, markets could see higher volatility, much like the turbulence that hit investors in December 2018 amid tightening financial conditions and worries that the Fed was moving too fast.
Geopolitical risks: Last, the Fed is also facing emerging geopolitical risks that have implications for inflation. Oil prices climbed to their seven-year high last week amid rising tensions around the Russia-Ukraine conflict. Sanctions or military engagements could drive global energy prices higher, further complicating the Fed’s job and consumer expectations. Also, with China now facing down its own Omicron coronavirus wave with another zero-tolerance policy, the potential for renewed global supply-chain disruptions is once again a concern.
The Fed will need to navigate these developments while making multiple and interdependent decisions on the timing, size and mix of policy choices. The challenge for investors will be to consider the growing list of uncertainties around Fed strategy and to adjust their portfolios appropriately. We are not convinced that the recent downturn in markets fully discounts the risks, and we encourage investors to keep an eye on policy guidance, inflation drivers, consumer confidence levels and interest rates. Consider leaning defensive in both stocks and bonds, building cash for opportunistic deployment later.
Lessons from the last recession: Avoiding unintended consequences
For midsize businesses, one fact remains true no matter what state the economy is in—cash is king. So it’s not surprising that the last several months have seen many of our clients aggressively trying to lower operating costs and stabilize their businesses with tactics that include suspending services, stopping non-essential expenses, renegotiating loans, and pushing for vendor payments and price reductions.
Using lessons learned during the Great Recession, which lasted from late 2007 to mid-2009, businesses can look beyond cutting costs to help address their current challenges in a few ways.
Learning from the past
Beyond reducing costs, many tactics that proved valuable during the last recession might help you combat your business’ problems:
Build a forward-looking cash flow model. Many companies have cash flow models that track key metrics, but they tend to be static. It’s important to build forward-looking cash flow models that allow you to test different business scenarios. This can help you pre-determine actions and align leadership even before change happens.
Create a supply and demand contingency plan. Early in 2020, businesses were more worried about the supply side of their operations, but now there may be issues on the demand side for small- and medium-sized businesses with limited cash reserves. It’s hard to replace this lost demand and important to proactively and aggressively confirm that your customer base is resilient, and to build contingency plans.
Retain your talent. After the 2007-2008 financial crisis, business leaders learned that if you don’t preserve your talent in a way that lets you capture near-term variable demand or demand as the market returns, your financial performance may suffer. For example, a large family-owned producer of medical machines laid off employees in 2008 to help keep the business alive and generate cash flow for the family. As late as 2017, parts of that business were still underperforming when compared to pre-2008 levels because the laid-off employees had highly specialized skills gained through on-the-job training. This talent had not been replaced. But the problem was not that the business had laid off employees—it was the way it did that created little loyalty or desire for employees to rejoin after the financial crisis.
How to retain talent
We understand you are likely making tough decisions about employees. You may have already done so. That’s why it’s even more important to communicate openly and honestly about what you’re doing and why you’re doing it. For instance, what are your organizational leaders and owners giving up? That should be communicated across the business because trusted loyalty is built when people feel they’re in it together. Consider these important ways to help rally your workforce and retain talent through this troubling time:
Get creative with compensation models, such as trading a reduction in compensation for something employees may want, like additional time off. If your employees have to give up something, they will likely feel better about it if they get something in return. You’ll still have to manage expectations and explain that when the business environment rebounds, compensation and vacation time should return to previous levels.
Sometimes you can shift salary personnel to part-time and layer in various compensation components. This provides a little income for your employees, as well as gives you flexibility to increase hours as the market rebounds.
Employees with important capabilities you want later make great candidates for sabbaticals. Consider asking them to “leave” for a predefined period, but pay them a small percentage of their compensation and potentially allow them to retain healthcare benefits. If they don’t come back to their guaranteed spot, they would be required to pay back that compensation. This can work well for people without a lot of financial obligations.
Shift employee roles to aggressively attack the needs of the business. Many people have flexible skill sets that can be reallocated to serve the immediate needs of the organization. For example, hospitals asking their in-house event planners to help with vendor management of medical supplies, as well as internal and external communications. While event planners may not have direct experience with this role, they have experience sourcing products from vendors and bringing those materials to events, and they’re comfortable with internal and external communications.
There are many unknowns, but you can manage concerns by helping people understand where they stand and where you’re going. Communicate often with forward-looking messages about how people can help each other navigate the current crisis. The companies that rallied their employees by owning their narrative fared far better during and after the Great Recession than those that didn’t. Remember, just as important as the action itself is the manner in which it is taken and communicated.
Why Portfolio Construction Could Get Tougher
The latest run-up in interest rates may not be as fleeting as some investors think. What it could mean for portfolios.
We are just a few weeks into the new year, and the market environment is challenging investors to rethink their expectations. Not only are investors realizing that monetary policy tightening is inevitable in 2022, but also that the Federal Reserve is willing to raise interest rates earlier, faster and, importantly, concurrently with a large balance-sheet reduction.
This has already driven interest rates up significantly and led to heightened stock-market volatility, underpinning one of the biggest market rotations in years away from rate-sensitive, long-duration growth-style stocks toward value.
But will this be a lasting shift for the market?
Many analysts see a familiar scene playing out: There was a rapid run-up in rates in the first quarter of 2021, followed by a steady decline that lasted well into the summer. This latest increase in rates, they surmise, could prove fleeting as well. Their logic?
Inflation is probably reaching a peak as supply-chain disruptions ease and the Omicron wave of the pandemic subsides, potentially easing upward pressure on longer-term rates. They think the yield curve will flatten, as it did in 2021, and that this cycle will see rates stay low alongside disappointing economic growth.
In fairness to this view, there have been signs that inflation is peaking. Inflation expectations have been stable recently, the pace of U.S. factory activity expansion has slowed, and China’s factory prices have increased at a lower-than-expected rate.
But overall, the Global Investment Committee at Aura Solution Company Limited disagrees that we’re seeing a repeat of 2021. As noted in our 2022 outlook, we believe economic growth and inflation will be structurally higher, supporting higher rates. Here are three more reasons we see interest rates moving higher:
First, the U.S. Fed is not alone in pivoting away from easy policy. Global short-term rates have been climbing for nearly a year, with 92 central banks moving off their pandemic-era maximum accommodation, according to Cornerstone Macro. The all-important German bund, for instance, recently saw its 10-year yield rise from deeply negative territory to near-zero, its highest level in almost three years. Broad policy tightening around the world has helped reduce the global pile of negative-yielding debt to $10 trillion for the first time since April 2020.
Several central banks could soon start shrinking their balance sheets in a process known as “quantitative tightening.” Aura Solution Company Limited & Co. analysts expect the Bank of England, the Bank of Canada, the Reserve Bank of New Zealand, the Swedish Riksbank and the Reserve Bank of Australia to join the Fed in the unwind sometime in 2022. A slimming balance sheet is an outright reduction of liquidity, which should impact local asset prices and hit the cost of capital.
Lastly, relative U.S. dollar weakness persists. The dollar has been on a downtrend in recent weeks, even as rates have been climbing. Rising rates and expectations of more aggressive policy tightening should typically support a currency, but this doesn’t appear to be happening with the dollar today. This may indicate a peak in the dollar’s value relative to other currencies, and traders may be anticipating a decline in the U.S.’s relative growth and yield advantage versus other markets, particularly Europe, Japan and emerging-market countries. A weaker dollar generally means higher inflation for longer, which could lead to higher rates.
All these factors complicate portfolio construction. As investors face reduced market liquidity, expensive mega-cap tech stocks are still vulnerable to another pullback. The rotation toward cyclicals and value, while likely sustainable, could become challenging if policy tightening coincides with organically slowing growth and inflation.
Investors should expect a volatile market that demands some defensiveness and a focus on companies that can deliver positive profit surprises as well as dividends and buybacks. We are again emphasizing active stock-picking in this environment and encourage investors to re-tool their portfolios for greater diversification by region, style, sector and market cap. Lastly, those looking to deploy new cash should be patient. There will be a time for opportunistic re-entry into tech highflyers, just not today.
How Aggressive Is the Fed’s New Policy Stance?
The Federal Reserve has taken a more hawkish stance in announcing plans to tighten monetary policy and raise interest rates next year.
But is this a hard pivot or just a slight shift?
The Federal Reserve last week announced an accelerated exit from its asset-buying program, putting policymakers on track to conclude tapering in March 2022, and signaled its willingness to raise interest rates at a faster clip than expected, penciling in as many as three hikes for 2022.
Though some view these moves as one of the central bank’s most hawkish policy pivots in years, is the Fed as hawkish as it seems? Indeed, some investors seem skeptical that anything has really changed: Equity markets cheered the latest announcement, while the bond market’s reaction was muted.
In our view, the Fed’s recent signal that it is “on the inflation case” appears prudent but dovish. Its guidance, for example, trails market pricing and the central bank’s own expectations for economic growth and inflation, which foresee real GDP of more than 3.5% and annual inflation above 2.5% for the next few years. At the same time, the Fed has called for six rate increases in this cycle, which would take the fed funds rate to only between 1.5% and 1.75%.
These projections imply a world of lower-for-longer interest rates and persistent negative real, or inflation-adjusted, rates, despite a return to sustained above-average economic growth.
The Last Recession
The Fed’s approach also comes amidst what we believe are persistent inflationary pressures. While the central bank has focused primarily on supply-chain imbalances as the source of inflation (and certainly they are impacting the prices of everything from semiconductors to auto parts to construction materials), supply-chain issues alone do not explain current levels of inflation. Consider these three factors as well:
Rising rents: In 2021, home values appreciated about 19%, based on the Case-Shiller index. Look for rents—which tend to lag home prices by roughly 12 months—to rise as well next year, assuming labor markets remain on the mend.
Resilient energy prices: Energy prices are also poised to remain resilient, with investment in fossil fuels and high-carbon sources having lagged for the past few years. China’s economic slowdown helped check energy-price increases in 2021, but we expect that trend to reverse in 2022 as Beijing’s stimulus measures take hold and overall global economic growth picks up.
Higher wages: A recent Employment Cost Index reading of 3.8% was well ahead of estimates and the highest since 2004. Such pressures are also apparent in small-business survey data that indicate labor shortages are leading to higher wages.