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Looming Recession – A Boom or Bust for Investors?

Looming Recession – A Boom or Bust for Investors?

April 07, 2023

Key Takeaways

  • A U.S. recession has been highly anticipated since mid-2022. However, the risk of a deep or drawn-out recession has fallen in recent months.
  • Equities have already experienced a significant pullback, pricing in a future recession.
  • Bonds are an attractive option given recent price declines and yield increases.
  • As always, it is important to stick with your long-term allocation and avoid attempting to time the market.

 

A Highly Anticipated Recession

Many economists and investors entered 2023 with a clear narrative: the U.S. would face a recession in the next 12 months. The Fed spent the last year aggressively raising interest rates to combat sky-high inflation. The resulting increase in borrowing costs will likely lead to a slowdown in growth, a rise in unemployment, and a deterioration in manufacturing and housing activity. The rate increases have already created enormous stress on bank balance sheets, resulting in several high-profile failures. Fed chairman Jerome Powell repeatedly stressed his commitment to bringing inflation back down to the central bank’s 2% target, even if it meant bringing “some pain to households and businesses.” In his speech at Jackson Hole last year, he stressed that “these are the unfortunate costs of reducing inflation.”[1] Even following March’s banking crisis, the Fed moved forward with a 0.25% rate increase.

Given the Fed’s clear intention of taming inflation at any cost, economists increasingly expect that the U.S. will fall into recession in the near future. According to the Wall Street Journal’s January survey of economists, forecasters place a 61% probability on a recession occurring in the next 12 months.[2] This was even before the recent round of bank failures. A separate recession probability model managed by the Federal Reserve Bank of New York that is based on Treasury spreads pegs recession probability by March 2024 at 58%, the highest probability using this model since the early 1980s.[3]

 


Source: WSJ Economic Survey Jan 2023

Still, capital markets appear to be shrugging off recession talks and concerns over banking contagion. This is probably due in part to the fact that the economy continues to exhibit strong fundamentals. A 6.0% CPI reading in February 2023 shows that inflation continues its steady decline from its peak of 9.1% in June 2022.[4] So far, the labor market has remained surprisingly strong. The U.S. added more than half a million jobs in January, doubling economists’ expectations, followed by another strong month in February. Consumer spending continues to rise and seems far from recessionary levels. Most economists still believe we will enter a recession, but most believe it will be relatively shallow and short-lived. The collapse of several U.S. banks in March have only reinforced these predictions, since the Fed now has more reason to ease off its rate hikes in the near term.

What to Expect within your Portfolio

Given the likelihood of recession, many investors are wondering how to position their portfolios to weather the storm. It’s logical to be concerned about equity markets during economic slowdowns, given that they usually coincide with falling stock prices. However, markets are forward-looking and will often react in anticipation of future events. U.S. equities entered 2022 near record highs but fell by more than 25% by October. The correction had more to do with the anticipated impact of future rate hikes than with concerns for present economic fundamentals. The Fed turned increasingly hawkish in early 2022 as inflation soared, and even though corporate earnings had not yet dropped, investors began to expect a future decline. Although U.S. equities have recovered some of those losses in recent months, the S&P 500 is still down about 14% from its January 2022 highs.[5] Although stocks may fall further from here, one thing is clear: the market is discounting a recession that was not on most investors’ radars one year ago, and the possibility of a recession has at least partly been factored into current prices.

Bonds are commonly considered to be safe-haven assets during times of economic stress due to their subdued volatility profiles and low correlations to stocks. Government bonds also provide a guarantee of principal that can’t be found in equities or corporate bonds. If we assume that the Fed is nearing the end of its rate hiking cycle (which we think is likely), then most of the pain in the bond market is behind us. In addition, bonds now pay yields that are significantly higher than they were just one year ago. These factors have made bonds attractive not only for their ability to offset portfolio risk, but also for their income generation potential.

How to Position Yourself for Success

Most importantly, each market and economic environment is unique, and it is impossible to know how different asset classes will react if the economy does in fact enter a recession. History shows us that markets recover eventually. As investors, we need to ensure that our portfolios are positioned to experience the rebounds that inevitably follow market pullbacks. Market rebounds often happen quickly, and some of the best days in the market will immediately follow the worst days. Missing those best days can dramatically lower your long-term portfolio returns.

 


Source: JPMorgan Asset Management [6]

If you are concerned about the impact that a recession may have on your financial plan or portfolio, consider the following:

  • Do not make any dramatic changes to your portfolio in an effort to time the economic cycle. This will often do more harm than good.
  • Maintain a diversified portfolio of stocks, bonds, and real assets at a risk level that aligns with your long-term goals.
  • Start an emergency savings fund containing at least 6-12 months of living expenses if you do not already have one. This will give you the means to remain invested during bouts of market volatility.
  • Review your cash holdings. Higher interest rates are now available and can provide a larger cushion in case an economic downturn occurs.

As always, you should reach out to your Financial Advisor if you have any concerns. This would be a great time to review your financial plan and long-term portfolio strategy.

 



[1] FederalReserve.gov

[2] WSJ Economic Survey Jan 2023

[3] NewYorkFed.org

[4] Bls.gov Consumer Price Index Summary

[5] Finance.yahoo.com

[6] J.P. Morgan Asset Management analysis using data from Bloomberg. Returns are based on the S&P 500 Total Return Index, an unmanaged, capitalization-weighted index that measures the performance of 500 large capitalization domestic stocks representing all major industries. Indices do not include fees or operating expenses and are not available for actual investment. The hypothetical performance calculations are shown for illustrative purposes only and are not meant to be representative of actual results while investing over the time periods shown. The hypothetical performance calculations are shown gross of fees. If fees were included, returns would be lower. Hypothetical performance returns reflect the reinvestment of all dividends. The hypothetical performance results have certain inherent limitations. Unlike an actual performance record, they do not reflect actual trading, liquidity constrains, fees and other cots. Also, since the trades have not actually been executed, the result may have under- or overcompensated for the impact of certain market factors such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. Returns will fluctuate and an investment upon redemption may be worth more or less than its original value. Past performance is not indicative of future returns. An individual cannot invest directly in an index. Data as of December 31, 2022.