In 1910 a series of forest fires in Montana, Idaho, and Washington, known as the “Big Blowup” burned three million acres in just two days. As one of the worst fires in American history, this event forced the United States Forest Service to create policies to deal with forest fires. Over the years, policies changed from attempting total fire suppression to allowing small fires to burn and even starting controlled burns. Like smaller natural fires, controlled burns aim to balance growth and destruction to create an environment ripe for growth. Controlled burns remove dead leaves and branches which encumber the growth of new plants, increase nutrients in the soil, and reduce the spread of pests, diseases, and the threat of larger, hotter, more destructive wildfires.
Economics is similar to ecology. Whether financial, sociological, or ecological, they both study and measure systems. In an economy, capital thrives in an open and competitive environment, unencumbered by debt riddled competitors. In a forest, plants and animals thrive in an environment free from excessive dead leaves and branches, and invasive species. The theory of Creative Destruction argues that long-standing institutions and/or assumptions must be destroyed to free up finite resources and energy for innovation. Similarly, wildfire management uses controlled burns whose destruction allows for new growth.
While this concept focuses overwhelmingly on growth, the goal of Federal Reserve policy is to balance the speed of growth as measured through inflation with stability in the employment market. If the economy is like a forest, then the Federal Reserve (the Fed) has been executing a controlled burn by raising interest rates. A mix of dovish monetary and fiscal policies since the Great Recession, combined with the effects and aftermath of the global economic shutdown due to COVID-19, created a financial environment poised for a “Big Blowup” style fire due to runaway inflation. 2023 will tell us how well the Federal Reserve’s wildfire management has worked.
2022: We Didn’t Start the Fire – But the Fed Did
A red-hot U.S. economy, paired with unreliable supply chains and heightened geopolitical pressure, created the potential for out-of-control inflation. The Fed’s response was late, dictating an aggressive increase in interest rates (to control a larger than expected fire). This delayed and dramatic response caused a drop in stock and bond prices. The Federal Funds Rate (the average interest rate that banks pay for overnight borrowing in the federal funds market) rose from 0% to 4.5% in 2022, the fastest change in rates since the Volcker era four decades ago.
The U.S. stock market had its worst year since 2008 with large cap stocks dropping -19.4%, mid cap stocks losing -14.5%, and small cap stocks finishing the year down -21.6%. International developed markets fared slightly better, losing -14.4% while emerging markets dropped -20.6% (source: The Sherman Sheet).
Much of the negative performance was due to a change in market perception rather than earnings destruction. We know this because market fundamentals remained strong this past year. The 2022 earnings growth estimate for S&P 500 companies is approximately 5.2%. Over the past 12 months the unemployment rate decreased from 4.0% to 3.7% while adding an average of 408,000 new jobs, and wage growth was at 5.1%. These positive growth numbers are not typically correlated with a recession. However, conditions could worsen if the Federal Reserve lets its fire burn too hot or for too long with high interest rates. At GreenUp, we believe we will know whether the Fed’s controlled burn was successful in the first part of 2023.
GreenUp’s Outlook for 2023
In the previous two quarterly market updates, we referred to a “growth recession,” a period during which corporate earnings continue to grow despite economic deterioration. The first two quarters of 2022 were negative (which meets the technical definition of a recession), however the third quarter had positive gross domestic product (GDP) growth and the fourth quarter of 2022 is likely to come in slightly positive. While the Fed’s GDP forecast for the first half of 2023 is negative, international supply chain issues have increased the variability in quarterly GDP measurement, causing forecasts to be less reliable. Thus, we expect economic growth through 2023 to mimic rolling hills, with contraction followed by growth and vice versa. Since the U.S. economy is dipping in and out of recessions, we will switch our term from a “growth recession” to a “rolling recession.”
GreenUp believes this rolling recession will be mild due to the strong fundamentals exhibited by corporate earnings growth and consumer spending. As the Federal Reserve increases the temperature of their controlled burn, the Federal Funds Rate is expected to peak in March 2023 at a terminal rate of 5.0-5.25%.
Higher interest rates slow down economic activity as it becomes expensive for businesses to borrow. While this creates a more difficult environment, is not insurmountable for well-run companies. The challenge for the Federal Reserve lies in setting the appropriate interest rate level/temperature of the fire. The Fed needs to find the rate at which unprofitable corporations, whose cashflows are only sufficient to repay the interest on their debt but not the principal (known as “zombie companies”), burn up while not harming well-run profitable corporations. The destruction should usher in an economic environment with less inflationary pressure.
With corporations and consumers starting 2023 fundamentally stronger than they have been in years, we do not expect a severe recession unless the Federal Reserve significantly exceeds its targeted 5.0-5.25% terminal rate. Instead, we believe our current rolling recession will peak as a mild recession in the first half of 2023 and transition into a market expansion in the second half of 2023 or first half of 2024. The destruction caused by the Fed’s interest rate “controlled burn” will clear the path for a more attractive business environment with controllable wage increases and moderate earnings growth.
Investment Themes for 2023
Based upon equity valuations, we will continue our tilt towards small cap, mid cap, and large cap value stocks due to superior pricing and earnings growth potential, as well as tilting towards domestic stocks. GreenUp portfolios will maintain our thematic investments with the US Global Jets ETF (ticker: JETS) as consumer spending and TSA checkpoint numbers return to pre-COVID trends, and with the iShares Semiconductor ETF (ticker: SOXX) as a momentum play that does well in positive economic conditions.
GreenUp expects continued yet reduced volatility in fixed income as interest rate risk subsides with the Fed finding its terminal rate. We will continue to favor shorter duration investments for now but will slowly increase duration through 2023. Since rolling recessions tend to be mild, we are favoring higher yielding investment grade corporate bonds, which tend to have low default rates even in recessions, over treasury bonds. In a recessionary environment, we remain cautious with our high yield exposure. Since floating rate bonds tend to have higher credit risk and interest rates have already increased significantly over the past year, we will reduce our exposure to floating rate bonds in 2023. Finally, we are adding convertible bonds into the portfolio which should benefit from an improving economic environment.
GreenUp is also incorporating alternatives into client portfolios this quarter. Alternative investments are not necessarily considered long-term growth investments, but they do reduce the volatility of portfolios due to their low correlation to equities and fixed income and add additional diversification in an uncertain environment. These investments are not dependent on corporate earnings and provide income streams unrelated to traditional fixed income investments. Once the economy shows signs of a market expansion, we will likely decrease our exposure to alternatives.
Final Thoughts
While 2022 was a difficult year and we continue to face economic and market challenges as the new year begins, we believe investors should remain invested. There is no way of knowing when the next market cycle will start, however the controlled burn will eventually end, and new growth will begin. Ideally, we will see an economic environment with lower inflation, moderate wage growth, continued low unemployment, and increasing corporate earnings. Inflation has been trending lower several months in a row and if this trend continues, it would be a signal for the Fed to extinguish the fire.
Recessions are a favorable time to invest because investments tend to be reasonably priced or even underpriced. When the media headlines are predicting doom and gloom and cable news programming is dominated by discussions of recession, it may be a signal that we are near a turning point. Investors are usually paid for the correct allocation of capital. As Warren Buffett, the most successful investor of the 20th Century, once said about his investment strategy: “We simply attempt to be fearful when others are greedy and to be greedy when others are fearful.”
Recessions also provide a reminder to focus on financial planning. High inflation and down markets offer a real-world pressure test of your plan. If you have not reviewed and updated your financial plan with your GreenUp wealth advisor recently, the beginning of a new year is a great time to review your investment strategy and progress towards achieving your goals.
Summary
- Controlled burns are used in wildfire management to create an environment for new growth in forests. The Federal Reserve (the Fed) is executing a “controlled burn” by raising interest rates to control inflation and promote future economic growth.
- The Fed’s response to inflation was late, leading to an aggressive change in the federal funds rate from 0% to 4.5% in 2022. This delayed and dramatic response caused a drop in stock and bond prices.
- Much of the negative performance was due to a change in market perception since corporate earnings growth was positive and unemployment remained low.
- Economic conditions could worsen if the Federal Reserve lets its fire burn too hot or for too long with high interest rates.
- The U.S. economy is in a “rolling recession” alternating between periods of growth and contraction which may end in the second half of 2023 or first half of 2024.
- Recessions are a favorable time to invest and offer a real-world pressure test of your financial plan.
GreenUp Portfolio Updates
Active Allocation Models (Capital Appreciation, Growth, Balanced, Capital Preservation, and ESG)
We continue to overweight Large Cap Value, Mid Cap Value, and Small Cap Value with risk targets at 110% of their benchmarks. We are selling iShares US Medical Devices ETF (ticker: IHI) and Innovator S&P 500 Ultra Buffer ETF (ticker: UAPR) and adding to iShares Semiconductor ETF (ticker: SOXX) while reducing the allocation to US Global Jets ETF (ticker: JETS).
Due to an increasing interest rate environment, we are targeting a 75% duration of the benchmark, and are over allocating to investment grade corporate bonds for greater yield. We are adding iShares 1-3 Year Treasury Bond ETF (ticker: SHY) and iShares 0-5 Year Investment Grade Corp Bond ETF iShares Core US Aggregate Bond ETF (ticker: SLQD) and removing iShares Core US Aggregate Bond ETF (ticker: AGG) and Invesco Senior Loan ETF (ticker BKLN).
Many of the portfolios will see the addition of alternative investments First Trust Alternative Opportunities Fund (ticker: VFLEX), CION Ares Diversified Credit Fund (ticker: CADUX), and MainStay MacKay Convertible Fund (ticker: MCNVX).
Large Cap Stock Model
We are selling AAPL, ABC, TGT, NVS, UL, COIN, SNOW due to poor valuations or negative cashflow and adding EBAY, SNY, FISV, ABDE, CVS whose valuations are now at a level to support addition to the model.
Tactical Equity Model
The quarterly trend turned negative on March 4, 2022 and remains negative. The model is in cash with periodic trades in and out of the market.
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.
