Is the Economy Strong Enough to Handle Higher Rates?

Is the Economy Strong Enough

Is the economy strong enough to handle higher rates, or is inflation so high that we’re in for a painful fight?

If you watch the financial news, you’ll hear vocal cases for positive scenarios (“soft landing” where growth slows enough to tame inflation) and negative ones (“only a recession can rein in prices”… or worse, we’ll see stagflation).

You might recall Yogi Berra’s quip that it’s tough to make predictions, especially about the future. We like this one from him better: “It’s not the heat, it’s the humility.”

The “heat” of course is economic news and market reaction; the “humility” is avoiding the noise and following a discipline.

We’ll share our latest thoughts on the current state of the economy, inflation, and the markets, then turn to the more important, objective indicators guiding our investment approach and decisions.

The Economy

Last week’s jobs report highlighted that the economy is still running strong. New jobs exceeded expectations, the participation rate improved slightly, and wages didn’t rise. Stocks and Treasury bonds both sold off, expecting the Fed to remain aggressive on raising rates.

Underneath those headlines, however, are signs of economic change. Some large companies in tech and retail reported plans for layoffs or a hiring freeze, while others reported an increase in inventories as demand began to shift.

Companies also reported growing concern that rising costs would be hard to pass along to buyers, indicating that corporate earnings—which have been very strong post-pandemic—may weaken compared to forecasts later this year.

On the consumer side, spending remains strong, but it is coming on greater credit card use and dipping into savings. There is cash on the sidelines, particularly among the most wealthy 40%, but the trendline is a minor concern as consumers begin to be stretched.

All-in, we see some storm clouds—weaker corporate earnings and consumer spending—and as we have written since January, when we began making shifts in certain portfolio allocations based on objective historical trends, we continue to think at least a mild recession is a reasonable possibility over the next 12-18 months.

Inflation

The level of inflation, currently running over 8%, continues to be a major factor. A tight labor force is a key variable, and talk of layoffs and peaking wage growth (5.5% in April, 5.2% in May) hint that inflation may be peaking.

Underneath that news, however, are signs that inflationary pressures persist. While job vacancies fell in manufacturing and goods as the pandemic shut-down fades, vacancies actually ROSE across the services sectors. Services are a bigger part of the US economy, and higher vacancies reveal labor markets are still tight there. Finding and retaining workers remains a challenge.

All-in, we continue to think inflation has likely peaked this summer, but that it will remain entrenched, perhaps exiting 2022 around 4%-5%. How it comes down will be determined either by aggressive rate hikes or natural erosion as consumers balk at higher prices. We see early signs of the latter, which we would prefer.

Markets  

While the economy is humming but perhaps peaking, equity markets have already reacted to some extent to persistent inflation and a slower economy.

Big Tech—as measured by the Nasdaq 100—was down over 27% this year alone at one point in May. The S&P 500, the most widely followed indicator, was similarly down over 18%, with Retail and Banks down about 32% and 21%, respectively. Those have each rebounded slightly in the past two weeks.

Bonds have made even larger adjustments. Short-term rates have risen quickly as investors anticipate aggressive rate hikes, and longer-term rates have risen (less quickly) as investors fear inflation and a slowing economy. As yields rise, bond prices fall, with Treasuries down around 8% year-to-date and investment grade credits down 10%-12%. Those are big moves for bonds.

Highly speculative markets—such as unprofitable tech and cryptocurrencies—have been hit dramatically, down 50% or more from peaks last year. We continue to believe excess needs to be cleaned out here, with the Nasdaq possibly losing perhaps 500 companies out of roughly 3500, and crypto miners and exchanges exiting the market due to liquidity challenges.

All-in, we believe markets are pricing in at least a mild recession already over the next 12 months. We see suitable entry points for long-term investors in some areas, although we are not calling a bottom yet. Stocks are not yet a bargain compared to bonds, when comparing earnings yields and bond yields. We expect significant volatility in both bonds and stocks to continue throughout the year.

Investment Approach

Broadening the perspective, at the beginning of the year we assessed the current environment for rates and the economic cycle, as well as market fundamentals, and made the following observations:

  • When real interest rates are very low, returns from both stocks and bonds tend to be low in the coming years. Last year, rates were in the bottom 20% of historical observations; historically, this condition has produced, on average, negative returns for bonds in the next five years, and meager returns at best for stocks.
  • The current level of inflation (4% at least, but as high as 7% or more) implied a challenging period for both stocks and bonds.
  • The current trajectory of rate hikes implied a challenging period for stocks and bonds. They tend to struggle in periods of rapid rate increases.
  • Stocks and bonds tend to trade more closely together in periods of crisis. We have observed this condition again this spring, as Treasury bonds have not shown the protection expected.

For these reasons, in particular for clients with spending requirements over the medium term or a certain risk profile, we increased our hedges to possible recession and higher inflation, within balance, to help guard against excess volatility.

Broadly, here is our positioning for investors:

  • Maintain long-term equity allocation (favor quality cyclicals and underweight Big Growth). For investors with long time horizons, we see select opportunities currently for new investment or rebalancing into equities.
  • Look to moderate equity volatility nearer term (reduce small stocks and emerging markets, add investments with lower volatility profile)
  • Be selective in fixed income; add alternative sources for yield-enhancing, diversifying return streams.

Bottom Line

Markets are already pricing in a recession, in our view, and we would agree that one may occur over the next 12-18 months. We expect significant volatility in both equity and bond markets as investors navigate news about persistent inflation and a potentially slowing economy. Fears of stagflation should continue, if inflation indeed stays high as growth slows. That said, we see suitable entry points for patient investors with long time horizons. For investors with regular spending requirements or particular risk profiles, we do see challenging periods for stocks and bonds for roughly the next five years. As always, diversification across economic regimes is our best recommendation for navigating these uncertain times.

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