Looking Through Recession to Ultimate Recovery

The Dow and S&P 500 opened down but swung positive in late trading. Recession fears have accelerated over the past few days, pushing defensive sectors like consumer staples & utilities higher, and cyclicals lower. Most commodities are softening, including copper, gold, wheat, soy beans, cotton, lumber, etc. Only oil and natural gas are trading higher. The bond market is broadly higher this morning. I expected to see safe-haven Treasuries jump in price (pushing yields lower), but was surprised to see corporates (even junk) participating in the rally. Bonds are engaged in a tug-of-war between the Fed (pushing yields higher), and the fear of recession (pushing yields lower).

Fed Chair Powell said this week that he “hope[s]…growth will remain positive” as interest rates rise sharply and financial conditions tighten. The Fed’s primary and overriding goal is to break inflation, but if possible he’d like to avoid recession. That said, he expects to hike rates to “restrictive territory fairly quickly.” In other words, by next year borrowing rates will be high enough to restrain economic growth.

Recently in this blog I addressed the possibility that we are already in recession. New information this week lends itself to that conclusion. First, Consumer spending slowed more than expected during the first quarter. The Bureau of Economic Analysis (BEA) revised its estimate of US economic growth down to -1.6% from the previous estimate of -1.5%. We knew the economy had contracted due to slower government spending and destocking of business inventories, which were bloated. But whereas consumer spending was initially thought to have risen by a very healthy 3.1%, BEA now says it’s closer to 1.8%. That’s a rather large revision and it will probably materially alter investors’ view of the economy.

Second, the Atlanta Federal Reserve Bank’s “GDPNow” index, which tracks in more or less real time how the economy is faring, fell to -1% yesterday. That is, it suggests second quarter US economic growth fell 1%. Coming on the heels of the BEA data above, we may have just met the traditional definition of a recession: two consecutive quarters of contraction.

Finally, yesterday’s Personal Income & Spending report confirmed we have seen the peak in inflation. Consumer spending rose 2.1% from year-ago levels in May, and the core inflation rate on that spending slowed to 4.7% from 4.9% in April. Both measures were a bit lower than economists expected. Today’s ISM Manufacturing report also confirmed that wholesale price inflation is slowing.

The data suggest a host of implications. If this is recession, it catches most economists and investors by surprise, and seems to confirm our new view that economic & market trends are changing much more quickly than is typical. The pain of this down-cycle may be over relatively quickly. Next, it’s hard to escape the conclusion that we’ve had it pretty easy so far. A recession without massive layoffs, bankruptcies and foreclosures should be fairly short and shallow. Jenny Harrington, CEO of Gilman Hill Asset Management, reminds us that this downturn isn’t as bad as the dotcom bust or housing crisis. The pain so far has been concentrated in the stock and bond markets, and she says we’ve already done most of the work bringing down valuations to normal levels. All this implies that the “second half of the year won’t be as bad as the first half.”

In order to arrest the stock & bond market slide and set the table for recovery, we need to see lower inflation and a less aggressive Fed. I imagine Fed Chair Jerome Powell is just as surprised as everyone else by how rapidly recession expectations are now taking hold. He’ll have to grapple with the fact that his monetary policy is already beginning to have the desired effect: slower growth and lower inflation. We expect to see more evidence of this in the near future, and think there’s a good chance that the Fed pauses interest rate hikes before year-end. The bond market seems to agree that the Fed won’t follow through on its full tightening plan. Treasury Inflation-Protected (TIPS) bonds are at this moment building in lower inflation & interest rate expectations (i.e. 3.3% average inflation over the next two years).

In the meantime, capital markets will likely remain volatile. Investors are hostage to macroeconomic data, as well second quarter earnings season, which is nearly upon us. While it’s possible that the June 17th low for the S&P 500 may hold, it’s equally possible we’ll find a new lower level. Our own technical and valuation work suggests a base-case scenario in which the index may bottom around 3,500, bringing the total bear market correction to about -27%. Our worse-case scenario envisions a bottom around 3,100, representing a -36% correction. In other words, we’re already most of the way there, and the stock market is beginning to get attractive. Michael Darda of MKM Partners says “This not the time to get negative on equity markets,” but rather the time to start thinking about buying opportunities.

As long-term investors, we agree. For most of our investment strategies, we’ve been sitting on additional cash awaiting some clarity on the macro environment. Up to this point, we’ve de-emphasizing the more cyclical sectors like technology and consumer discretionary. But now, with growing evidence of a slowing economy and peaking inflation, we are approaching the point of maximum bearishness. it’s time to get constructive. Any further weakness in the stock market should be viewed as a good buying opportunity. Should the S&P 500 fall to 3,500 we plan to shift about half of the extra cash into the cheapest sectors of the stock market, which we believe will benefit the most from the ultimate recovery. Subsequently, if our worst-case scenario is realized and the market falls toward 3,100, we plan to get fully invested with an eye to recovery beginning in the fourth quarter.