The stock market is a device for transferring money from the impatient to the patient.
~ Warren Buffett, American business investor and philanthropist
We’re going to get inflation down […] that means we are going to be aggressive on rate hikes and we may have to take the risk of causing some economic damage.
~ Fed Governor Christopher Waller (July 7th, 2022 speech to the National Association for Business Economics)
On the economy
Technically, the U.S. is not in a recession. The official recession definition requires a look back at how our economy performed over the previous six months using Gross Domestic Product (GDP) data. In the first three months of 2022, GDP fell 0.36%, or 1.4% annualized. In late July we will learn how much the U.S. economy grew, or shrunk, in the second quarter, although it is expected to shrink. Until then, it may just feel like a recession without the confirming data. (Graph on the right depicts projected future GDP in italics.) It has been 13 years since the Great Financial Recession crushed U.S. and world economies. To build back from those ashes, governments offered ultra low, and in some places negative, interest rates, which accompanied low inflation. Easy access to capital was a hallmark along with muted economic growth. 2022 has ushered in an abrupt change to this world order. There was always going to be distress for consumers as world banks raised interest rates to stem excesses, but Russia’s invasion of Ukraine in late February has added more havoc than any could have predicted. Even if there is a recession, many economists do not expect it to be devastating or on par with other recent declines in 2001 or 2007-2009. The U.S. consumer is entering this period from a position of strength; household finances appear to be in good order and banks have plenty of lending capacity for those who need it. Business, which were forced to become efficient and fiscally savvy during the worst days of the pandemic, have hired only the employees that they need. There will be some job losses but most workers do not need to panic about mass layoffs that usually define downturns. This is the good news. On the other hand, there is no easy or near term solution to the biggest problem, which remains the massive disorder of supplies and the demand for them. The imbalance is the cause of much of the 40-year high in inflation. Prices in goods for which we cannot defer purchase of, such as gas and food, means Americans are not able to save as much. Savings have dropped to 5.2% of disposable income, near a 30-year low. Consumers of all income strata say that they will postpone large purchases this year.
It is difficult to see how the energy shortages, caused by shutting Russia's oil barrels out of the world's supply, will improve anytime soon. The U.S. in particular has moved too far towards renewable resources to turn back on oil spigots quickly. Sadly, for all the focus on renewable energy options, we still get nearly 82% of our energy from fossil fuels. This is not much changed from 1990 when it comprised 88% of our consumption.
Most of the data that we collect to gauge the economy – such as GDP, unemployment percentages, inflation and retail sales numbers - lags our day-to-day experience. These "leading" indicators are readily available but can be misleading and inaccurate if not considered within the big picture. The stock market is a leading indicator, as is the bond market.
Like the stock market, the bond yield curve is sending signals of economic stress. When the current yields of the various terms of U.S. Treasuries are plotted on a chart and the shorter-term issues are yielding more than the longer-term, recession is said to be imminent. Take this yield curve chart from July 7th showing 2-year yields higher at 2.99% than the 10-year at 2.93%. The “inversion” signals growth expectations are diminishing as short-term interest rates are rising. Business applications are another leading indicator. New applications are up in the West and slightly in the Northeast, but have turned negative in the South and Midwest. Mortgage applications for new home purchases are still growing month over month, but barely. All of these leading indicators are quick to change ahead of the economy and as mentioned, can be deceiving if reviewed on their own. But taken together, the leading and lagging data points to a clear slowdown.
On the markets
Since January, the S&P 500 Index has turned in the worst return of any period going back to 1970, 52 years ago. Only a handful of other years in the last century have had such negative performance, down over 20% through the end of June. But each time previously the S&P 500 has rebounded during the second half of the year. The economic circumstances in those other years were arguably not as hairy as the set facing consumers and businesses in 2022.
Amongst the poorest performing stocks have been long duration, or growth, companies. Long duration stocks promise robust future earnings but have no current earnings or cash flow. When money is cheap and free flowing, making risky investments in businesses with weak financials, but exciting potential, is a compelling proposition. These stocks are the first to sell off when the macroeconomic picture worsens.
There were many different types of long duration stocks that pulled in massive amounts of money and attention during the 2020-2021 pandemic investing era – the memes (GameStop, AMC, Hertz), “blank-checks” or SPACs (Nikola, Virgin Galactic) and many other innovative technology, consumer discretionary and healthcare companies. The NASDAQ index, the best proxy for these companies, began faltering in November and is down 33% from that peak.
The counterpart to long duration is short duration. These are stable companies, often referred to as value, and give investors much higher certainty in their earnings capability now and in the future. As interest rates rise, companies with strong earnings, healthy cash flow and less debt, become more attractive to investors. Investors have sold off these names too but typically, the most dependable of this group are financials, energy and utilities.
To date, long duration stocks remain more expensive than the short duration stocks. Based on the Russell 1000 Growth Index, which represents the 1,000 largest growth companies in the U.S., investors are paying 21 times future earnings. The Russell 1000 Value Index is priced at just 13 times future earnings. Therefore, growth is notably more expensive than value, even though those stocks have fallen more, and may have still more to fall in this grizzly market.
It is not just stocks that have struggled. The bear market has come for most every type of security in most every industry that is not energy, food commodities or the U.S. dollar. Traditional safe-haven securities like gold and government and corporate bonds have lost value. Cash, due to inflation, is also losing dominance. Crypto-currencies like Bitcoin, which at one point were considered a hedge against inflation, have cratered. Given that the Federal Reserve is increasing rates in the face of an economic slowdown and potential recession, not lowering them, the U.S. dollar has become more attractive. This has investors selling gold and also bonds off all maturities that were issued at lower rates. Gold has dropped some 10% from its earlier high this year as have bonds with a maturity in the 5-7 year range.
Global markets, other than those in oil rich countries like Saudi Arabia, have struggled aplenty. Fears of a recession while other central banks are also raising interest rates has induced loads of volatility and knocked markets off. France and Germany’s major indices are down some 15-20%. Fairing somewhat better has been the U.K.’s FTSE 100, which is heavily composed of commodity, energy and consumer staple companies, rather than technology, but still down over 7%. Only recently has China’s momentum picked up following a long stretch of Covid-induced, economic smothering lockdowns this spring. The People’s Bank of China has begun lowering interest rates to juice their sluggish economy; the Shanghai index only fell 7% in the first half of this year.
Bear markets in the U.S., defined by 20% below a recent high water mark, have historically lasted 180 days. June 30th was the 196th day of the current downturn. It is likely this market will not end until the Federal Reserve feels that inflation and employment have come into balance.
On personal finance
So what to do when expecting a recession? When an economic malaise is telegraphed so pointedly and repeatedly as this one has been, it is understandable to feel frustrated and worried. This can also be a good time to review your finances and update your financial plan. There are opportunities and beneficial actions to take if you know what to expect.
For starters, your emergency fund probably feels reassuring right now. Most people have been able to build up their savings account and keep it flush during the pandemic. Even as some accounts became somewhat diminished by the retail therapy craze of the last two years, spare cash is still cool. If you do not have savings, it is time to budget and get back into the savings habit. For those still working, reserves of three-to-six months of living expenses for a household with two workers is recommended. Retirees should consider 12-to-24 months of expenses, mostly to avoid forced selling of assets in down markets.
Keep investing. Do not take it just from us; billionaire investor Warren Buffett agrees. He wrote in 1987 that his modest goal is to “attempt to be fearful when others are greedy and to be greedy only when others are fearful”. It is very difficult to keep putting money into markets when prices have collapsed but dollar-cost averaging into every type of market condition, especially downturns, has been shown to be one of the most effective ways to build wealth.
Ditch the high interest debt and credit cards. As rates are increasing, so is the interest on your variable credit cards. Paying off or moving to lower rate options could be the best investment you could make at a time like this.
Although the job market is incredibly tight and wages have been increasing in many sectors, loss of income is still a risk that concerns many. Creating additional sources of income is always smart when possible. Just ask the next millionaire, as it has been said that millionaires have on average seven sources of income, both active and passive. Active income is that from the day job or a side hustle like consulting or a “gig” job. Passive income comes from becoming a landlord, investing in a private business, interest on a loan and investment dividends. First build the active income and then put that money towards building up passive income investments.
Finally, review your investments and financial plan. We do not believe financial plans should be a "set it and forget it" item to check off of your to-do. As markets bob and weave, so does life. We are here to help you and enjoy working with individuals, families and businesses to make durable and flexible plans for the future.