Economic growth spiked coming out of the pandemic trough in 2021 with the aid of aggressive fiscal & monetary support. Late in 2021 that growth began to cyclically slow down leading to volatility in the first half of this year followed by sizable rallies and selloffs. The selloffs have been exacerbated by geopolitical shocks, tightening monetary policy, and inflation. The rallies have been characterized by optimism that these sources of contention are showing signs of dissipating amid record low sentiment in equity pricing. At the center of these contentions is inflation. High inflation is typically an offshoot of strong economic activity and loose monetary policy. Symmetry implies that a slowdown in economic growth should coincide with a peak in inflation which would be a welcomed respite for investors allowing the Fed to lighten up on rate hikes. This “dovish pivot” was the root of the 17% rally in the S&P 500 in mid-June through mid-august, but the crux of this optimism is that slowing economic growth risks a recession and the inflation we are experiencing now is unique in many ways. In response to this Fed chairman Powell’s recent comments at Jackson hole sent equity markets lower after this dovish pivot never materialized. On the contrary Powell's speech was short, but explicit in relaying the central bank’s commitment to fighting inflation even at the risk of recession.
And so markets have been range bound in a purgatory state trying to handicap whether there will be a recession (hard landing), or no recession(soft landing). The timing of this possible recession also muddies the view. We’ve had two quarters of falling real GDP which meets the criteria for a “technical recession” but record low unemployment means the labor market will need to deteriorate before the effects permeate to corporate earnings which is what equity markets care about. Also there is some tension in those negative prints as inventories and residential investment dragged on GDP. What's more is that all six variables used by the NBER to make its recession determination have expanded since December ‘21 making the likelihood of the US officially being in a recession in the first half of 2022 low. Taking all this into account the recession would likely be pushed out several quarters.
If all of that sounds a bit contradictory or unassertive, that's because it is. In many ways that sums up the challenge for anyone trying to get a read on the global economy – all of these things continue to happen at the same time. The market itself is unsure but I can give my opinion on how I think the next 18 months in the economy will unfold.
My opinion is that although we are in a technical recession, we are not in an actual recession … yet. But what's important is that economic momentum has clearly been lost. The economy began naturally slowing at the end of 2021 but typically a cyclical slowdown needs to be accompanied by some kind of shock to tip the economy into a recession. Throughout history most of these shocks tend to either be runaway inflation, central bank policy error, or an exogenous shock. It could be argued that in the first half of this year we are getting all three of these. What's more is that many of the usual recession indicators such as yield curves and business surveys are pointing towards a substantially weakening economy. Inflation stabilized in August but is still over 6% above the Feds long run target. The mechanics of Year-over-Year inflation measuring and base effects means that it can come down quickly but with elevated global energy prices I find that unlikely to happen soon enough for a dovish pivot in monetary policy to occur. And this dynamic provides an important distinction of this cyclical growth slowdown to the most recent ones which occurred in 2013 and 2018 which ended in a soft landing(no recession). During those growth slowdowns inflation was below target allowing the Federal Reserve to ease policy quickly. This time inflation is running at 40 year highs and the central bank is pumping the breaks on the economy. Furthermore China, which has been a global economic growth engine, is sputtering. And Europe is paying the price for their nonsensical energy policy which is going to severely hinder EU industrial activity.
Even the most optimistic of economists would struggle to find reasons for upside surprises amidst the continued period of weak consumer and business sentiment, slowing manufacturing data, and elevated energy prices. So my opinion is that a hard landing is the likely outcome.
And so what does all of this mean for your investment portfolios? First, a hard landing means that earnings estimates are still too high and a defensive equity positioning is prudent. In a recent note (here)we expanded in detail on why our large cap, dividend-focused bias to equity investing is meant to endure periods of turmoil while still creating cash flow for investors. This also means favoring sectors that tend to have more defensive characteristics in recessionary environments. On the fixed income side it means having high credit quality, low duration instruments diversified across issuers. You will remember we took steps to bolster our fixed income allocations in 2018 and hedge our sensitivity to interest rates in January of this year in anticipation of a rising rate environment (see here).
But it also means that a selective buying approach is important especially in the riskier/growth pockets of the market. In a past note (here) we expanded on the perils of timing the market and accordingly we think there are some investments whose prices reflect a hard landing risk, others do not. Nevertheless we think adding risk in this market needs to be done cautiously and patiently over the next 12 months.
As always we are happy to discuss.
Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.
Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable. Any comments and opinions made in this correspondence are subject to change without notice. Past performance is no indication of future results.