If you’re an optimist, earnings season was broadly encouraging for investors. Companies did better than their lowered expectations and held to the view that trends remain better than feared.
Likewise, job growth is still positive despite higher rates, housing has rebounded, and consumers continue to spend, although they are “trading down” as inflation bites.
From this perspective, the Fed might successfully guide the economy to a “soft landing,” meaning that we may even avoid recession as inflation comes down to tolerable levels.
If you’re a pessimist, you’ll note the bond markets continue to forecast recession, as the yield curve remains inverted. The stocks of regional banks are down dramatically since March, reflecting concern that higher rates and bad debt in real estate loans will take a toll. And inflation remains elevated even as growth might slow.
From this view, there are plenty of overhangs to any positive news.
Which side is right? In this note, we put these points in context and provide our take.
Taking the long-term perspective, our expectations continue to be:
- Inflation is slowing but likely to linger, forcing the Fed to stay vigilant. The good news is that inflation is probably nearer its peak for this year. How quickly the Fed reduces rates depends on priorities between fighting inflation and helping banks by lowering rates.
- Capital markets are tighter now, reducing lending activity going forward. This is already happening, especially following the recent banking crisis. Starkly tighter standards historically precede recession. We’ll touch on this below.
- A recession of some kind remains probable late this year or early next. Whether we experience an official recession, or a protracted period of slow growth—whereby different sectors enter and exit mini-recessions at different points—remains to be seen. Many manufacturing sectors and rate-sensitive sectors like housing construction already entered recession last fall and show signs of stabilizing now.
- Companies still face earnings risk later this year and next year, as the economy absorbs higher rates.
The Most Anticipated Recession in History?
Markets have been forecasting recession since as much as a year ago. It hasn’t happened yet, and economic activity remains solid overall. Why is recession taking so long to get here, if it does at all?
The simple answer is that there is a lag effect to rising rates, which we have discussed, perhaps as much as six to 12 months.
But there are factors this time around that we believe are pushing the lag out even further and softening the impact of rising rates:
- The economy is less sensitive to higher rates, in our view. Many mortgages have low, fixed rates, and supply remains limited as homeowners aren’t rushing to sell and housing affordability is now tighter. Although higher rates may slow activity, they haven’t yet undermined the fundamental health of the housing market.
- Participation rate in the labor market is historically low and only now starting to improve. It fell to its lowest point in modern history following COVID. More people participating in different parts of the labor market helps reduce the impact of job losses in some sectors.
These factors may help buy time for the economy to absorb higher rates and adjust without crashing. But we do not believe they fundamentally change the dynamics of inflation and how to contain the threat.
Impact of Higher Rates Starting to Show
Despite headline strength in labor markets, we believe cracks are starting to show from the rapid increase in rates. Higher rates have:
- Exposed uncompetitive, low-yielding bank deposits. Higher rates have exposed the uncompetitively low yields on deposits at smaller community banks. They may need to raise rates to keep deposits, which would have a negative impact on their profitability. To some degree, this risk is reflected in stock prices of small banks already.
- Accelerated distress in commercial real estate. Delinquency rates are up among commercially secured bonds. As of late April, these junk bonds traded at about 75 cents on the dollar, particularly for loans secured by office buildings, where vacancies are at historic highs already. Notably, over half of office and multi-family real estate loans mature in the next three years; refinancing may be difficult if credit markets are skittish.
- Forced distress in leveraged loans. These loans are typically higher risk sources of cash for acquisitions, recapitalizations, or growth. Delinquencies are up, and about half of these loans mature over the next four years. Unprofitable tech companies, for example, may have to restructure.
- Increased level of bankruptcies. Weekly bankruptcies among small companies are higher in 2023 compared to the last spike at the outset of the pandemic.
With this backdrop, it is no surprise that banks’ lending standards have already become much tighter. Higher rates affect bank profitability if banks need to raise yields on deposits or if loans go bad. It is harder to get credit these days for many small and medium-sized businesses.
Tight lending standards generally lead to slower economic activity. Notably, the number of banks reporting tighter standards is beginning to approach levels seen during the last four recessions (1990, 2001, 2008, and 2020).
We anticipate that tighter lending conditions will once again have a meaningful impact on broader economic activity later this year. The fact that debt secured by commercial real estate matures in stages over the next four years may help spread the pain of workouts and economic dislocation.
Recap: Our Recommendations
We started making defensive adjustments to investment strategies over 18 months ago as certain risks were becoming imbalanced.
To highlight our research decisions during this period:
- When rates and inflation were low but starting to rise, we added defensive allocations to our equity exposure, including hedged ETFs, structured income notes, ETFs using covered call strategies, and equities with factors that historically bring less volatility.
- In fixed income, we put a focus on quality, sold our high yield positions, and—as rates got higher—swapped some alternative investments into better yielding government bonds and mortgaged-backed agency bonds.
- We’ve also included TIPS for inflation protection, where appropriate.
- If markets reprice risk and return, we could look to become more aggressive.
During this period, we have also been counseling business owners, families, and nonprofits about the rising risk of recession, and how to adjust as necessary.
We don’t recommend a change to investment strategy for our clients at this point, if your circumstances have not changed.
Any questions or concerns, please let one of us on your team know.