During the 1960’s Italian film director Sergio Leone became famous for creating the “Spaghetti Western,” a genre of movies set in the American Wild West yet produced by filmmakers in Italy and Spain. Leone’s most popular films were a trilogy starring Clint Eastwood. The third film of the series, The Good, the Bad, and the Ugly is listed on Time’s “100 Greatest Movies of the Last Century” and Variety magazine’s list of the 50 greatest movies. Towards the end of the movie, a gun duel between the three main characters provides the climactic drama. Let’s look at the three main characters dueling it out in our economy.
The investment markets have provided plenty of drama during the first half of 2022. This has been the worst six months for stocks in half a century. However, the movie is not over yet, and we do not plan on leaving the theater early. In this quarterly market commentary we will discuss the Good (consumer spending and corporate earnings), the Bad (inflation), and the Ugly (recession or growth recession). How will an economic duel determine the fate of investments?
The Good: Low Unemployment and Strong Corporate Earnings
Although it may be difficult to believe, we still see good aspects to this economy, and they are not particularly difficult to find. As mentioned in GreenUp’s previous quarterly market updates, the US consumer and corporate earnings act as a foundation for the US economy. Unemployment is at historic lows and Corporate Earnings Growth is on pace to grow at 10.1% for 2022. These numbers suggest that our foundation is strong.
The US labor market currently boasts a 3.6% unemployment rate, with wages increasing at 6.5% year-over-year in May. High wage growth and low unemployment typically do not signal a recession. Through the remainder of 2022, we expect the unemployment rate to slowly increase, as companies slow down or cease hiring due to increased economic pressures. Even with the added pressure, we expect the job market in the US to remain strong.
Perhaps more encouragingly, corporate earnings growth remains elevated for 2022 at 10.1% year-over-year and is forecasted to grow by 9.5% in 2023. There is a disconnect between the media’s message of a certain recession and the average equity analysts’ forecast of strong economic growth. We will continue to scrutinize corporate earnings for signs of consumers’ eroding purchasing power due to high inflation. In the meantime, corporations are making money, have high profit margins, and great balance sheets, making them well prepared for multiple market outcomes.
There is no question that consumers and corporations are healthy (although it may not feel that way), and as a result the economy is also robust. What is uncertain is how long the US economy can remain healthy in an environment with continued high inflation and energy costs.
The Bad: Inflation
Inflation continues to be high and pervasive with the May Consumer Price Index (CPI) year-over-year change at 8.6%. We all experience it, specifically at the grocery store and gas pump. Although the current state of the economy is good, continued high inflation will force consumers to either:
- Change their spending habits, as the increased cost of necessities such as food and energy will leave less money available for discretionary items, or
- Take on more debt to continue current spending habits, which will decrease long-term financial security
Neither of the above scenarios are enviable and if not altered, will lead us into a recession without further action from a third party such as the Federal Reserve (the Fed). Although we are experiencing the highest inflation levels in four decades, we are encouraged that the Federal Reserve is on the right track with its current monetary policy. The Fed’s actions have consequences which make financial transactions more difficult, but not impossible. Although “tighter” monetary conditions may feel a bit uncomfortable, the Fed’s plan to increase interest rates and engage in quantitative tightening appears to be working.
For those who were worried that the Federal Reserve was not moving quick enough to combat inflation, their fears can be alleviated. During the second quarter of 2022, the Federal Reserve increased the interbank lending rates from 0.25% to 1.75% with a goal of 3.40% by year end. Most of this interest rate increase is expected within the next two months. Year to date, mortgage rates have increased from 3.22% to 5.70%. This means a $100,000 30-year mortgage went from $434 per month at the beginning of the year to $580 per month at today’s interest rate (an increase of $1,752 per year for each $100,000 borrowed for a house purchase). That means $1,752 per year which is not being spent on discretionary items such as dining out, entertainment, clothing, etc.
Pulling double time, the Federal Reserve has also engaged in quantitative tightening. The Federal Reserve of St. Louis defines quantitative tightening as fiscal policies that reduce the size of the Federal Reserve’s balance sheet. As we mentioned in last quarter’s commentary, from 2020 to 2022 the Fed’s balance sheet increased dramatically to $9 trillion and now plans to decrease its balance sheet to about $4-$6 trillion over the next decade. To accomplish this goal, the Fed is targeting a reduction of approximately $45 billion per month by not reinvesting the money from maturing bonds. This amount will accelerate to about $95 billion in September and stay at that pace until further guidance is given by the Fed.
Most individuals will not see the impact of quantitative tightening. But for institutions, especially banks, quantitative tightening matters. One of the Federal Reserve’s day-to-day duties is to make sure there is enough cash in the banking system to support liquidity. When you deposit money into a bank, the bank will lend a portion of your assets to a third party to earn interest. If you withdraw 100% of your account, what happens to the portion of the assets that were lent out to a third party? The bank must borrow those funds from the Federal Reserve. In other words, the Federal Reserve makes sure that our money is available should we want to withdraw it (a novel idea in many countries around the world). If there is not enough money in the financial system, it is possible for liquidity to dry up which leads to a credit crisis (the most recent of which was the Great Recession from 2008-2010). Quantitative tightening impacts banks’ liquidity because it limits the money supply. The potential of a liquidity issue is one reason why the Federal Reserve is taking a slow and measured approach to decreasing its balance sheet. At this point, the process seems to be working.
In other words, the Federal Reserve is acting to fight inflation and we are seeing progress. Unfortunately, such progress is slow and sometimes takes the form of economic deterioration. We will wait to see whether the Federal Reserve can engineer a “soft landing.” Which leads us to the question, what does a soft landing look like for corporations, consumers, and investors?
The Ugly: Recession or Growth Recession
Raising interest rates and quantitative tightening aim to decrease gross domestic production (GDP) growth in the US. This is and will continue to be the Federal Reserve’s plan for combatting inflation. However, slowing GDP growth creates a risk of recession, and we believe that a recession is already here. The technical definition of a recession is two consecutive quarters of negative gross domestic product (GDP) growth. For the first quarter of 2022 GDP growth was -1.6% and the Atlanta Federal Reserve Bank estimated real GDP growth for the second quarter at -2.0%. It appears that it is no longer a matter of if we expect to enter into a recession, but what type of recession will it be- a deep recession or a growth recession (what the Fed considers a “soft landing”)?
With the data available at this time, GreenUp believes we are in the midst of a growth recession for the remainder of 2022 and possibly into 2023. However, if high inflation remains persistent, it increases the likelihood of a deep recession.
The term recession can certainly be scary. However, knowledge is power which is why it is important to understand what has historically happened to the investment markets during the past recessions. The US stock market dropped an average of 35.8% from peak to trough during post-World War II recessions, with the Great Recession of 2008 being the worst period at -55%. While these numbers are truly ugly, the S&P 500 year-to-date is already down approximately 22%. This means we may have already experienced two thirds of a typical downturn.
Another thing to consider is that recessions and bear markets do not last forever. A typical bear market lasts one-and-a-half years with more recent bear markets moving faster than past bear markets. This is why it is important to recognize that we have already experienced eight months of a down market.
As mentioned above, we believe our economy is in a growth recession at this time (or what the Fed considers a “soft landing”). A growth recession mimics a recession. We see economic deterioration: unemployment increases while credit conditions tighten. However, in contrast to a deep recession in which we see a deterioration of corporate earnings, a growth recession is an economy where companies are still growing profits. In our opinion, historically low unemployment (and job openings at record highs) and resilient corporate earnings growth support the likelihood of a current growth recession followed by an eventual market recovery.
How the Duel Will End
How will the economic duel between the Good, the Bad, and the Ugly play out in our movie? As we watch the data, there is reason to be hopeful as our bad character, inflation, will not win the fight in the long run. There are signs that high inflation is beginning to subside, but there is no definitive trend yet. It may take some time before inflation eases its negative effect on our economy.
What about our ugly character, recession? Excluding the COVID-19 economic shutdown, it has been a long time since the economic crisis of 2007-2009 (“The Great Recession”). Recessions are a normal part of the economic cycle and typically happen more frequently (every five years on average), which is probably why our current economic downturn seems uglier this time around. It is also likely that this probable recession is an extension of the COVID-19 pandemic which started a chain reaction, beginning with lockdowns, followed by an overheated economy driven by pent-up demand, then high inflation accelerated by accommodative monetary and fiscal policies and supply chain disruptions. Ultimately, recessions are temporary, and our ugly character will not prevail.
What should investors do during this duel? Investors should cheer for the good guy, turn down the negative noise generated by the media, and stick to their long-term financial plans. We believe fixed income investments will stabilize going into the second half of the year. We also believe that certain equity valuations look attractive, although the possibility of a deepening recession means there is still downside risk. As inflation eventually subsides and the recession ends, stock valuations, growth prospects, and consumer spending will push equity market valuations up again, and the good guy will be victorious.
In the next few quarters the bad guys may gain the upper hand. However, in the long term, in every movie, whether it is a production from Hollywood, Italy, or anywhere else in the world, the good guy always wins.
Summary
- Consumers and corporations are healthy (although it may not feel that way), and the US economy is robust. Unemployment remains at historic lows, wages increased at 6.5%, and Corporate Earnings Growth is on pace to grow at 10.1% for 2022.
- It is uncertain how long the US economy can remain healthy in an environment with continued high inflation and energy costs.
- Inflation continues to be high and pervasive with the May Consumer Price Index (CPI) year-over-year change at 8.6%.
- The Federal Reserve Bank (the Fed) is fighting inflation through increasing interest rates and quantitative tightening, and we are seeing some progress. However, this means the Fed’s actions are slowing down the economy, creating the risk of a recession.
- We may already be in a “growth recession.” If high inflation remains persistent, it increases the likelihood of a deep recession.
- Investors should stick to their long-term financial plans. As inflation eventually subsides and the recession ends, stock valuations, growth prospects, and consumer spending will push equity market valuations up again.
GreenUp Investment Models Update
Active Allocation Models (Capital Appreciation, Growth, Balanced, Capital Preservation)
As the S&P 500 Index’s 200-day moving average moved outside the 95% confidence zone, we increased our risk budget to 110% of the benchmark. We added Innovator S&P 500 Ultra Buffer ETF (UAPR) and increased the weighting of Alger Weatherbie Specialized Growth Fund (ASMZX), iShares S&P 500 Value ETF (IVE), US Global Jets ETF (JETS), and Avantis International Equity ETF (AVDE). We decreased the weighting of Avantis Emerging Markets Equity ETF (AVEM), iShares Semiconductor ETF (SOXX), and iShares US Medical Devices ETF (IHI).
For the fixed income portion of our active allocation models we reduced duration, buying iShares 20+ Year Treasury Bond ETF (TLT), iShares Ultra Short-Term Bond ETF (ICHS), and Thompson Bond Fund (THOPX), and selling iShares Core US Aggregate Bond ETF (AGG).
Large Cap Stock Model
We sold Disney (DIS), eBay (EBAY), CarMax (KMX), Lyft (LYFT), Novartis (NVS), Phillip Morris (PM), and Uber (UBER), reduced our holdings in Visa (V) and Mastercard (MA), and bought Target (TGT), Parker-Hannifin (PH), FedEx (FDX), and Diamondback Energy (FANG).
Tactical Equity Model
We maintain a defensive posture with periodic trades in and out of the market ever since moving out of the market on March 4 when the Bull-Bear Indicator entered bear status.
The performance of market indexes is discussed as indexes are generally well recognized as indicators or representations of the stock market or certain sectors. Market index performance does not normally reflect reinvestment of dividends or expenses, and you cannot typically invest in a market index.
GreenUp Wealth Management may discuss and display, charts, graphs, formulas, and stock picks which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. Consultation with a licensed financial professional is strongly suggested.
The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass.
GreenUp Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
