ECONOMIC COMMENTARY

CIO Note: Recession risks are on the rise

Global equities remain under fierce pressure as tighter monetary policy and high inflation bolster recession concerns.

Key takeaways

  • Recession risks are rising as inflation weighs on producers and consumers; however, a recession in 2022 still appears unlikely in our view.
  • The Fed is following a well-telegraphed path to a tighter stance; however, a decline in end demand alone is unlikely to solve the inflation issue.
  • Energy stocks led the market in 2021 and again year-to-date in 2022; however, there are several near-term challenges to consider.

Fanning recession fears

One of the biggest challenges that economists and investors are facing in the current environment is pinpointing the start of the next recession, and with U.S. GDP declining by -1.4% in the first quarter, recession expectations are on the rise.

Recessions are a part of the economic cycle. When asked if a recession is coming, one can always answer yes, as they are inevitable. The question is really coming from a place of preparation; in times of recession, jobs are less plentiful, wage growth slows or ceases altogether, savings becomes a source of income and overall household wealth declines.

From a company standpoint, it is even more critical to prepare for slower economic growth and demand well ahead of time, as companies which have historically weathered recessions more successfully are those which have the financial capital to avoid more permanent forms of cost cutting such as labor force reductions and closing/selling production facilities.

Historically, the depth and length of recessions have been dependent on the state of the economy leading up to them, and while every economic environment is different, the U.S. economy is facing some of the same challenges that preceded the 1980-1981 recession as well as the Great Recession of 2008-2009.

Higher prices are the result of strong consumer and producer demand, and companies are scrambling to hire workers to meet it. Labor shortages are forcing companies to pay higher wages and passing those costs through, in many cases, directly to the end buyer. Consumers are becoming increasingly hesitant to make large purchases at these increasingly higher prices, despite a job market which is perhaps the best in years across a wide swath of industries.

Low rates and ample liquidity created pockets of overvaluation and outright speculation over the past two years, with the massive gains – and now losses - in high valuation, high growth, zero profitability stocks similar to the tremendous overinvestment in the U.S. residential housing market leading up to 2008. Financial conditions are tightening, as shown below, as the combination of higher rates and inflation combine to weigh on everything from high yield spreads to IPOs.

With that said, a recession in 2022 still appears unlikely. Unemployment remains low, and while that can be precursor for recession, as outlined above, the fact that job openings continue to climb and now stand at 11.549 million speaks to corporate expectations of continued demand. While almost 2:1 ratio of openings to unemployed persons seeking work is pressuring wages higher, it is also buoying the Expectations Index within the Conference Board’s Consumer Confidence survey, which increased for the month of April despite continued inflationary pressures.

Both ISM PMI services and manufacturing surveys are also squarely in expansionary territory. Despite recent declines, at 57.1 and 55.4 respectively, both measures sit above their trailing 10 year average. Consumer balance sheets are stronger than they were coming into the Great Recession as well, with the personal savings rate at 6.2% versus 2.8% in November of 2007.

Finally, it is worth noting that industrial production continues to march higher, with factory output up +8.1% in the first quarter of the year. While manufacturing activity admittedly is less impactful to overall GDP than consumer activity, the potential for production to return to the U.S. and become a meaningful contributor to economic growth, rather than just a drag on our country’s trade balance, could be an unforeseen silver lining to the pandemic over the next several years.

Anticipating the Fed's next move

The new era of Fed transparency which began with more frequent press conferences following the financial crisis, culminating in current times with Chairman Jerome Powell being perhaps the most visible Fed Chair of all time has resulted in significantly less suspense when it comes to the actions taken in the Fed meetings. As such, it came as little surprise that in its early May meeting the Fed announced an increase in the fed fund target rate range to 0.75% to 1.0%. This was the first 50 basis point increase since 2000, and although the whispers were that the Fed could raise 75 basis points, our expectations for a 50 basis point move were met.

In addition, Chairman Jerome Powell and the other Fed governors committed to the near term commencement of quantitative tightening. Beginning in June, the Fed will allow for $30 billion in Treasuries to mature without replacing them and after three months, this will increase to $60 billion a month; mortgage-backed securities will also be allowed to roll off, albeit at a slower pace.

So where will the Fed go from here? According to the bond markets, the fed funds rate is likely to end the year between 2.50% to 3.00% - and that is up from the implied levels even 2 months ago. The implication is that the Fed will continue to effect 50 basis point hikes over the next 2-3 meetings, and that could continue into the fourth quarter if inflation remains stubbornly high.

It’s easy to take the stance that the Fed is behind in grappling with inflation, and as a result, they will raise rates to a level that will constrict economic growth. An alternative hypothesis is, similar to the natural tightening of financial conditions, a decline in consumer demand for goods could produce a multiplier effect in terms of inflation.

Prior to the pandemic, the percentage of consumer spending represented by services had been growing steadily over the prior decade. A massive decline in services spending due to Covid-19-related social restrictions coupled with fiscal stimulus payments translated to an almost overnight increase in the demand for goods.

With a shifting stance in the U.S. and Europe as it relates to Covid-19 restrictions, services spending is increasing on a monthly basis, as exhibited in the below chart. Normalized spending could help to easy supply chain pressures resulting in more modest price increases for end consumers.

As such, our view is that a combination of BOTH lower demand AND supply chain improvement will be necessary to get inflation back to the Fed’s target. The Fed’s ability to engineer a decline in demand through higher interest rates is not in question; rather, the ability to deliver just enough pressure to decrease demand while not plunging the economy into recession is the bigger challenge.

As for supply chain issues, China has represented the epicenter of those disruptions. While the rest of the world appears to be adopting a new course in terms of the Covid-19 challenge, China has reaffirmed its commitment to a zero-Covid policy, and as a result, recent outbreaks have resulted in concerns around long tail disruption for global goods production. More importantly in the short term, the unemployment rate is rising rapidly as 31 cities have implemented either partial or full lockdowns, and economic activity has slowed meaningfully over the past several months, falling into contractionary territory according to PMI figures. In our view, Chinese policy represents the biggest impediment to supply chain improvements over the next several months and may force the Fed to be as aggressive as the bond market is assuming it will be.

Assessing the outlook for energy

The energy sector has delivered meaningful gains for investors over the last 16 months, bouncing off an incredibly low base from the depths of the pandemic. As such, the sector weight in terms of the S&P 500 has grown as well, from around 2% during the pandemic lows to over 4.5% now. In terms of sentiment, the sector is in focus, as investors who have not participated meaningfully in the upside are considering whether to initiate positions, and those who have enjoyed the ride may be looking to take some gains.

In terms of long term positives for the sector, there is likely to be a continued supply/demand mismatch for oil later in 2023 and through 2026, which would point to sustained higher prices than those experienced prior to the pandemic. Disciplined capital allocation and a focus on profitability create the opportunity to benefit over time even if demand slips incrementally at certain points in the cycle.

ESG investors also appear to be considering the space in a new light, looking beyond divestment and thinking more in terms of responsible sustainability. In the near term, however, we believe the sector likely faces some short term headwinds. The war in Ukraine has created a war premium due to boycotts of Russian oil, but China’s consumption of Russian oil likely reduces the strain on remaining supplies, which we believe will push oil prices lower in the near-term. In addition, the demand destruction that we expect to result from a slower economic environment could push oil back into lower range than it trades in today, at least for several quarters as the economy readjusts.


Source: YCharts

We encourage you to reach out to your Wealth Advisor for a deeper discussion on the points above, or a review of your current plan to ensure it remains aligned with your long term needs and goals.

Shannon Saccocia serves as Chief Investment Officer at SVB Private, and is responsible for setting the overall investment strategy for the firm. She oversees the asset allocation, research, portfolio management, external manager search and selection, portfolio implementation, trading, and investment risk management functions.

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