02 Oct US stock and bond indices are down, and economic recession forecasts galore – time to panic?
Posted at 07:35h
in Blog
Author’s note: I managed investor funds as a fiduciary for the past four decades, with one goal –
to make my client’s wealth compound over tme. In writing this blog, I aim to cut through the
noise in the financial markets and help you make informed investment decisions. Instead of
creating economic and market forecasts, I listen to what the markets tell us now in decision making. I hope my comments are helpful to you. However, I welcome your comments and
critiques with equal interest. Let’s make it a two-way dialogue beneficial to all concerned.
Disclaimer: This piece is intended for educational purposes only and not to be construed as
investment advice. Please consult a qualified advisor before implementing any thoughts
discussed in this blog.
Equity Markets:
- US stocks (as measured by the S&P 500) are down approximately 6.9% from their peak inJuly but are up 11.7% year-to-date. Corporate earnings are expected to rise 1.1% in 2023and 12.2% in 2024 (source: FactSet) – which widely trounced calls for earnings collapsethus far this year. As measured by the price/earnings ratio, stock valuations are now at17.9 times the next twelve-month earnings – compared to the last five-year average ratioof 18.7 (no stock market bubble here).
Fixed Income Markets:
- Bond prices, as measured by the Bloomberg US Aggregate Bond Index, are downapproximately 22.1% since their peak in August 2020. The resurgence of inflation and anaggressive campaign to control it by the US Federal Reserve since March 2022 played asignificant role in the bear markets in the bonds.
- One of the most significant reversals in the fixed-income markets since the GreatRecession (2008 – 2009) is the revival of inflation-adjusted (real) interest rates. Forinstance, yields on ten-year US Treasury Inflation Protected securities rose from a negative1.17% in August 2021 to 2.2% at the end of September 2023 (Source: US Federal ReserveBank of St. Louis). The bond markets experienced similar real rate spikes across the boardin the yield curve.
- Since the Great Recession, the world’s central bankers have flooded their respectiveeconomies with liquidity via aggressive bond buying in the open markets, otherwiseknown as Quantitative Easing (QE). They have also driven interest rates on overnightdeposits to zero (ZIRP), forcing investors to accept negative yields on their bonds whenadjusted for inflation.
- According to a report from Cambridge Associates, approximately 40% of all outstandingsovereign debt in developed markets offered negative interest rates in August 2019, whichwas the peak level. However, this stockpile of negative-yielding bonds dropped to itslowest level in six years, with approximately $3.0 trillion of bonds crossing over to positiveyield territory in the past week alone (Source: Bloomberg).
- With peak inflation in 2021 experiencing its highest level in four decades in mostdeveloped markets, it is now hard to imagine the central bankers resorting to their ultraliberal monetary policies any time soon. Except for Japan, most major central banksworldwide have openly committed to their inflation-fighting stance and have raised short term interest rates to their highest levels since 2011. They are also on record now, statingthat the rates will remain higher until inflation is well under control, which could take a while.
The US Economy:
- One of the surprises for the economists who predicted a recession in the US economy in 2023 was robust consumer spending. Tight labor markets, a record low in unemploymentrates, and wage growth adjusted for inflation supported this consumer spending. Pentup leisure and travel demand postponed due to the COVID-19-related shutdown has also contributed to the economic growth.
- One of the conundrums in the financial markets is the muted impact of the Fed’s interestrate hikes on the US economy. Theoretically, the rate hikes should have induced a sharpeconomic contraction, increased unemployment, and dampened consumer demand.However, the current US financial data shows quite the opposite, with consumer spendingcontinuing unabated.
- The answer lies in the continuing trillion-dollar-plus budget deficit spending by the BidenAdministration for the foreseeable future. This spending nullifies the impact of the Fed’s rate hikes, and the US economy is chugging along as usual. However, it is worth notingthat consumers’ so-called “revenge travel and leisure” spending is now dissipating, butnot enough to induce a recession in 2024.
Investment Strategy:
- While rising interests are causing trepidation in the equity markets now, supported byreasonable valuations as measured by the price/earnings ratios and by increasingcorporate earnings in 2024, I call for maintaining a full weight for equities in the portfoliosand raising this allocation marginally to take advantage of current seasonal volatility. Mybasis for this recommendation rests solely on a no-recession forecast in the US economy.I do not see any reason for panic in the equity markets now.
- Bonds will likely face headwinds in the next twelve months as the Fed maintains itshawkish tone on inflation and interest rates. Progress toward the Fed’s inflation goals, asmeasured by the Personal Consumption Expenditure Index (PCE), is likely to be slow in2024. It requires a dogged fight to control inflation by maintaining the interest rates at thecurrent levels or higher for the foreseeable future.
- Bond markets are now repricing fixed income as an asset class by demanding higher yieldson longer-duration securities (term premium) and (real) interest rates adjusted forinflation. This repricing is also aided by the absence of central bank Quantitative Easing(QE) programs and the downsizing of their bloated balance sheets.
- Thus, I recommend shorter-duration fixed-income securities in the portfolios (with anoverall duration of less than three years). The US dollar will also remain robust againstsignificant currencies, aided by healthy US economic growth and the differential in realinterest rates.
- I am optimistic about robust US economic growth for the foreseeable future, aided by thereshoring of manufacturing from China, productivity improvements across the boardaided by artificial intelligence, and healthy US corporate/consumer balance sheets. Thus,I recommend an equity-biased portfolio approach to achieve robust inflation-adjustedreturns, notwithstanding any short-term volatility in the interim.
