Gravity Exists

focus

The Recession Playbook

July 25, 2022


While serving as the 12th Chair of the Federal Reserve, Paul Volcker Jr. pursued aggressive policy measures that brought inflation levels from a high of 14.8 percent (headline CPI) in 1980 to just 3 percent within three years. To reign in runaway prices the Fed, under Volcker’s leadership, implemented policies that helped drive the prime rate to 21.5 percent, leading to a recession and an unemployment rate of over 10 percent. The manufacturing sector was particularly hard hit as rising capital costs dealt a heavy blow to US companies already struggling with foreign competition. Throughout the painful transition, Volcker remained impervious to criticism from both Capitol Hill and the private sector. In a speech delivered in April of this year, Jay Powell — the 16th Chair of the Fed — noted that “Paul Volcker knew that in order to tame inflation and heal the economy, he had to stay the course,” adding, “he demonstrated resolve and integrity by refusing to be swayed by political expediency."

Unshakable ResolveWhile serving as the 12th Chair of the Federal Reserve, Paul Volcker Jr. pursued aggressive policy measures that brought inflation levels from a high of 14.8 percent (headline CPI) in 1980 to just 3 percent within three years. To reign in runaway prices the Fed, under Volcker’s leadership, implemented policies that helped drive the prime rate to 21.5 percent, leading to a recession and an unemployment rate of over 10 percent. The manufacturing sector was particularly hard hit as rising capital costs dealt a heavy blow to US companies already struggling with foreign competition. Throughout the painful transition, Volcker remained impervious to criticism from both Capitol Hill and the private sector. In a speech delivered in April of this year, Jay Powell — the 16th Chair of the Fed — noted that “Paul Volcker knew that in order to tame inflation and heal the economy, he had to stay the course,” adding, “he demonstrated resolve and integrity by refusing to be swayed by political expediency."

Recession Playbook

Our Quarterly Survey of Gravity Exists readers yielded a wealth of information about the economic and market sentiment of wealth managers and family office CIOs, as well as how they are steering client portfolios. While fewer than 100 questionnaires were returned, participation was significantly greater than the response to our first survey and represented well over $100 billion in discretionary AUM. The results were notable in uncovering a deep pessimism about both the US economy and financial markets, but restraint in portfolio adjustments. This suggests that, despite concerns about near-term volatility, most respondents continue to adhere to a disciplined long-term strategy. Meanwhile, our survey of managers and strategists revealed risk perspectives that differed significantly. This divergence among market seers underscores the historically anomalous macro setup facing markets today. To receive our sentiment and allocation research going forward, please contact us at survey@gravityexists.com.

Allocators face an uncertain second half of 2022 as overlapping macroeconomic risks, including inflation, geopolitical instability, and supply disruptions, cast shadows over all asset classes.

Most ominously, the possibility that aggressive central bank tightening may trigger a recession is forcing allocators to reconsider long-term return expectations. Several risk narratives have emerged as US investors reassess assumptions about the economy and financial markets.

Fed Watch: Reading the Tea Leaves

Despite the US Bureau of Labor Statistics releasing consumer price inflation data with a headline index registering a 40-year high of 9.1 percent, market analysts have predicted further price expansion is unlikely. “The strong bid for 30-year Treasuries suggests the market believes inflation has peaked. We would concur,” said Jefferies Equity Strategist Sean Darby. “The US yield curve has moved into a bull steepening.”

Other observers believe that even if inflation has peaked, policymakers are unlikely to change course until significant data has accumulated to indicate that price pressure is moderating.

“A year ago, 10-year Treasury yields were 1.3 percent. Today they are 2.9 percent,” noted Don Rissmiller, Chief Economist for Strategas. “A significant change in inflation has been priced in, and now concerns are about real growth.” Rissmiller expects a Fed funds hike of 75 basis points at the July FOMC meeting, noting Fed Chair Powell and his colleagues likely wish to avoid a stop-and-go monetary policy. “So until it’s clear inflation expectations are anchored for at least several months,” said Rissmiller, “it will be difficult to see tailwinds for risk assets broadly.”

Rissmiller is not alone in his views. In a note to clients issued last week, Lotfi Karoui, Chief Credit Strategist for Goldman Sachs, wrote, “policymakers are signaling they are determined to bring down inflation, even if that implies a fairly high risk of recession.” In Karoui’s view, the Fed’s commitment signals a willingness to allow deterioration of the labor market, carrying particular risk for growth.

While media attention focuses on FOMC rate decisions, a potentially more impactful actor for markets is its asset sales. The Fed began trimming its balance sheet last month, and expectations are the pace of the unwind will accelerate in September to $60bn of Treasuries and $35bn of mortgage-backed securities per month. Many analysts conclude that a pause in sales based on softening economic activity is unlikely.

“The Fed plans to let QT run in the background, and it seems very likely to me that balance sheet runoff keeps going even if the economy stalls,” said Morgan Stanley Chief Global Economist Seth B. Carpenter. “Chair Powell keeps reminding us that the FOMC wants the funds rate to be the tool of first recourse, so if we get to the point of the economy faltering, there will be room to cut.” Goldman’s Karoui concurs that “the QT-induced withdrawal of ‘excess liquidity’ has not even started.”

That Sinking Feeling

Our reader survey indicated deep pessimism for bond market returns, with most respondents anticipating negative headwinds for fixed income during the second half as the Fed moves to control inflation. Eighty percent of respondents anticipated negative headwinds while the AUM weighted response was over 90 percent.

A World Awash in Debt

Rising rates’ potential to derail growth may hinge on leverage embedded within the global economy.

The world has experienced two of the worst economic downturns since WWII in just over a decade. Central bank policies during the Credit Crisis and COVID-19 pandemic recessions employed significantly increased debt to help cushion the blows. Over the first five quarters of the pandemic, global debt as a percentage of GDP jumped 42 percent through Q1 ’21.

In a report issued by J.P. Morgan last week, Global Economist Joseph Lupton and his colleagues noted that much of the rise in leverage during the pandemic is due to contracting growth. Growth has subsequently rebounded, but global debt as a percentage of GDP remains 28 percent higher than at the end of 2019. They conclude this heavy debt burden threatens to tip the scales toward a recession.

“High debt levels are concerning against the backdrop of tightening financial conditions globally as inflation and inflation expectations move higher and central banks respond by continuing to normalize policy rates,” wrote Lupton. He identifies a concern that countries with fragile financial systems will be vulnerable if central banks raise interest rates too quickly and growth falters.

“The key to painlessly reaching sustainable debt levels is growth, as reopening dynamics facilitate strong income gains,” Lupton continued. “Absent strong growth, increased saving (through higher taxes from governments, or reduced spending across the spectrum) will be required.”

Are We There Yet?

A growing number of investors and strategists have concluded that the US is already in recession. “The US may see back-to-back quarters of negative growth already in the first half of the year,” according to Karl Haeling, Director of Capital Markets for Landesbank Baden-Württemberg in New York. “Even if strong labor market conditions prevent this from being classified as a true recession, many expect one by next year.”

A number of respondents to our Q3 reader survey share the view that a recession has already started. One senior advisor at a bank-owned RIA wrote, “the consumer is sending a clear signal that they believe we are in a recession, regardless of whether the technical definition has been achieved yet.”

This fatalistic perspective is also visible in Treasury markets, where the yield on 2-year Treasury notes now exceeds that of 10-year notes by over 21 basis points. The inversion of the US yield curve last week was a turning point, according to Robert Savage, Head of FX sales in the Americas for Bank of New York Mellon. This inversion may be the strongest indication yet that growth is due to contract [See Chart]. In a note published Sunday, Savage reminded clients that history suggests a period of modestly positive GDP can still be very painful for investors. “A recession did not follow the yield curve inversion in 1966, but it was a miserable market for risk then despite the technical growth.”

Pessimism, Not Panic

Among our readers, few respondents placed the likelihood of a US recession below 50 percent. Although not requested explicitly in the questionnaire, a significant number of respondents volunteered their view on timing, with the greater probability of recession coming in the next four quarters than before year-end. Interestingly, most respondents who placed the odds of a US recession at lower than 50 percent were in the top quintile by AUM.

Portfolio Strategy: Playing Defense

Even as yields have risen sharply and central bank tightening is poised to continue, many credit market experts argue strategic options capable of providing defensive outperformance are available to investors.

Goldman’s Karoui warns that the second half of the year will likely test the ability of credit markets to digest central bank tightening. Still, he argues that a path forward for risk management may be emerging. “Given the strength of balance sheet fundamentals and supportive technicals on the supply side, we think the bulk of this year’s spread widening is most likely behind us at this point,” Karoui wrote last week. “From a portfolio construction standpoint, we continue to recommend staying ‘up in quality’ across sectors and ratings, as well as ‘up in liquidity.’”

Karoui recommends Goldman’s Clients overweight Mortgage-Backed Securities versus Investment Grade Corporates, a view he has held since the start of Q2. His preference for agency MBS lies in its ability to withstand the effects of slower growth and hawkish policy because of the negligible credit risk in spreads.

Many strategists recommend scaling back exposure to the high-yield market. While the Barclays High Yield Index now stands at a premium of 5.3 percent to Treasuries, a level within the long-term average range, the rapidly decaying business cycle signals more pain ahead.

“A reasonable argument can be made that a credit default cycle has now begun, and investors

should expect to see HY defaults rise materially in the next 12 months, albeit from near record

lows of late,” said Nicholas Bohnsack, Head of Portfolio Strategy at Strategas. According to Bohnsack, bank loans should experience a retreat of similar magnitude with additional spread widening. “We now expect to see HY spreads finish 2022 above 600 bps, and likely above 700 bps as soon as end of Q1 2023.”

Equity Markets are also bracing for more pain.

Even after a 17 percent decline in the S&P 500 year-to-date, strategists warn that stocks could fall much further if negative fall earnings guidance weighs on valuations.

While consumer and technology sectors have felt the brunt of weakening sentiment, some analysts have identified other sectors potentially poised to thrive in a sluggish environment.

On July 15, RBC Capital Markets released a survey of their equity analysts, identifying segments of the equity markets that presented the most significant risks to investors and sectors that could outperform.

The most constructive performance outlook among RBC’s analysts was for US Energy. The sector now tops the bank’s expected performance rankings by a wide margin. RBC lifted the Energy sector to an “Overweight” recommendation citing attractive valuations, a strong earnings profile, and compelling dividend yield.

“Given current prices, product demand is likely to fall for both oil and gas, and ultimately this could drive a recession,” according to Biraj Borkhataria, who covers Oil & Gas integrated companies. “But the supply-side response has been slower than expected, so the fundamental setup is constructive.” Meanwhile, RBC MLP/Midstream analysts Elvira Scotto and TJ Schultz agree that energy stocks are attractive generally, concluding that “a short or shallow recession should not really impact our midstream companies too much, as it would not drive significant demand destruction.”

Although Energy was the clear winner of the survey, RBC’s research department also had favorable views toward portions of the healthcare sector and some REITs.

Some investors also see opportunities in relative valuations for mid- and small-cap stocks with the Russell 2000 trading at multidecade valuation lows versus the S&P 500 as measured by some metrics.

“We are now back to a level that we saw in 2001 following the dot-com bust,” said Tom Samuelson, Chief Investment Officer for Vineyard Global Advisors. “Once we reached that level, small caps were set up for a decade of outperformance.” Samuelson anticipates the US economy will likely experience a recession and that small caps will be poised for significant outperformance as it plays out.

Some allocators we spoke with in recent weeks have concluded that the coming market cycle is likely to be more difficult for passive investment strategies. With prospects for a higher cost of capital, macroeconomic volatility, and renewed focus on the quality of both credit and earnings, the argument for active management has strengthened considerably.

Think Tactically

While our survey of managers and strategists revealed some key differences in macroeconomic perspectives, respondents universally recommended a defensive posture for allocators. Nicholas Bohnsack — President and Chief Operating Officer of Strategas, for instance, recommends that allocators adjust to a neutral to tactically-negative position for equities, an underweighting for bonds, and an overweighting to cash/gold, with a small allocation to commodities. Lucas Kawa, a Director with UBS Asset Management, advised that investors considering a tactical asset allocation with an underweight to equities, neutral duration and neutral Credit positioning for fixed income, and an overweight in commodities — particularly energy exposures.

Sticking with the Plan

On average, respondents to our reader survey indicated a marginal fresh allocation to equity portfolios (less than five percent, with a roughly corresponding decline in cash), primarily as part of reweighting mandates. On an AUM-weighted basis, equity allocations experienced a marginal outflow into cash (less than four percent). Anecdotal evidence suggests that the culling of tech-stock managers by larger allocators was a driving force behind the decline. Unsurprisingly, fixed-income allocations saw a marginal outflow. The small percentage of respondents altering bond allocations primarily shifted to longer-duration bond funds.

How Bad Can It Get?

While almost all the advisors, portfolio managers, and strategists who participated in our recent surveys were relatively sanguine, few expect a setback for the economy and asset values to have a lingering impact.

Brian Reynolds, Chief Market Strategist for Reynolds Strategy, commented in a recent report for clients, “this is not a 2008-type of environment when pensions (the dominant global investor) were forced to sell credit because of margin calls they could not meet.” According to Reynolds, “the current environment is reminiscent of 2009-20 when credit funds hired by pensions were allowed to stop buying when there was macro turbulence but when things calmed down were expected to put that money to work.”

Since the 1980s, the FOMC has been increasingly transparent regarding its intentions during periods of economic stress. This pattern of signaling intentions has conditioned markets to anticipate swift intervention and has caused steepening to begin in advance of recessionary cycles. In the unique situation now facing the US economy, with long-term market inflation expectations muted and a seeming willingness by the Fed to accept recession to tame prices, the curve has inverted.

Playing OffenseSince the 1980s, the FOMC has been increasingly transparent regarding its intentions during periods of economic stress. This pattern of signaling intentions has conditioned markets to anticipate swift intervention and has caused steepening to begin in advance of recessionary cycles. In the unique situation now facing the US economy, with long-term market inflation expectations muted and a seeming willingness by the Fed to accept recession to tame prices, the curve has inverted.

This chart compiled by Strategas maps out the average valuation of large-cap US equities during different inflation regimes across the past 72 years. Based on this data point alone, the potential for further equity market declines seems significant regardless of whether a technical recession occurs.

Inflationary HeadwindsThis chart compiled by Strategas maps out the average valuation of large-cap US equities during different inflation regimes across the past 72 years. Based on this data point alone, the potential for further equity market declines seems significant regardless of whether a technical recession occurs.