Sunday, June 5, 2022

Recession Watch #4 - CEO's Urge Caution

In February, I began sharing that the risks of a recession were rising; those risks continue to increase, but there are reasons for optimism. In addition to hard economic data, I also consider qualitative data, which can be the opinions of subject matter experts or people in a position to have additional information. This week several Fed officials shared their views on the future path of interest rates. Several business leaders expressed concerns about the economy; those opinions should be weighed along with the market and economic data in forming an investment thesis.

Qualitative Data
Monday – Speaking at the Institute for Monetary and Financial Stability in Frankfurt, Germany, Federal Reserve Governor Christopher Waller said he's in favor of several additional half percent or fifty basis point increases in the Fed Funds rate until he sees "inflation coming down closer to our 2 percent target."

Wednesday - Speaking at a conference, JPMorgan Chase CEO Jamie Dimon said, "It's a hurricane. Right now, it's kind of sunny; things are doing fine; everyone thinks the Fed can handle this." "That hurricane is right out there, down the road, coming our way," he added. "We just don't know if it's a minor one or Superstorm Sandy or Andrew or something like that. You better brace yourself." In earlier comments, Dimon had characterized his concerns as storm clouds on the horizon. Those storm clouds have now developed into a hurricane watch.

Thursday - Speaking at a conference, Goldman Sachs President John Waldron said, "This is among — if not the most — complex, dynamic environments I've ever seen in my career." "The confluence of the number of shocks to the system to me is unprecedented."

Friday – In an internal email, Tesla CEO Elon Musk directed executives to pause hiring worldwide and said that 10% of salaried positions would be cut while hourly headcount would increase. Musk added that he has a "super bad feeling" about the economy. Musk later clarified that he expected the total number employed by Tesla to increase.

In an interview with CNBC, Cleveland Federal Reserve Bank President Loretta Mester said; "My starting point will be, do we need to do another 50, or not, have I seen compelling evidence that inflation is on that downward trajectory, then maybe we can go to 25" basis points, she said. "I'm not in the camp that thinks we need to stop in September." Many had expected the Federal Reserve to hike rates by a half percent two more times before pausing in September.

Quantitative Data
Tuesday - The Case-Shiller National Home Price Index showed a year-over-year change in home prices of 20.54%. I do not expect home prices will continue rising at this pace, nor do I expect home prices to fall dramatically. The pandemic caused a change in how people think about where they live and how they work. There are regional supply/demand imbalances that will continue.

Wednesday - The Federal Reserve Bank of New York lowered its 12-month recession probability to 3.71%. I don't put a lot of stock in the predictive ability of this indicator but that it is trending downward is encouraging.
The Bureau of Labor Statistics reported 11.4M non-farm job openings in the US. 

Thursday – The Department of Labor reported that initial weekly claims for unemployment insurance were 200K, down 50% from a year ago. Employment is a lagging economic indicator, and unemployment claims tend to rise during a recession. It is difficult to argue that we are currently in a recession, with unemployment claims at a 50-year low. 

Friday – The Bureau of Labor Statistics reported US Nonfarm Payrolls grew by 390K in May. The unemployment rate remained steady at 3.6%, payrolls grew as additional people returned to the workforce, and the Labor Force Participation Rate rose to 62.30%. There is a total of 5.95M unemployed people in the US.

Other Considerations
Several companies have lowered their earnings estimates but have primarily cited currency exchange risks from overseas operations due to the stronger dollar.
Despite the headwinds, few analysts have reduced their earnings estimates for the S&P 500.

Market participants are focused on things that feed into inflation and how it shapes the Federal Reserves' interest rate policy in response.
  • The war in Ukraine is a human tragedy; the resulting impact on global fuel and food supplies is inflationary.
  • Continued disruptions to supply chains related to COVID-19 are inflationary.
  • Increased post-pandemic consumer activity is inflationary.
  • The tight labor market is causing some wage inflation which is passed to consumers as higher prices. Employers have openings for 11.4M more employees while only 5.95M people are unemployed. The economy will need to slow to the point of job destruction to bring the labor market into balance.
There is evidence that tightening monetary conditions is slowing economic growth. The concern is that, as has happened in the past, to get inflation under control, Fed policy will have to become restrictive to the point of causing a recession. Given the level of uncertainty, the stated path of Fed policy, and statements from business leaders, continued defensive positioning in portfolio models is warranted.
  • When people hear the word recession, their minds go back to previous deep recessionary periods when they may have experienced financial hardship. I do not see a recession forming in 2022. The US economy is a big ship to turn, and with a tight labor market, an economic contraction would be difficult. People who are employed get a regular paycheck that they spend buying goods and services, which drives the economy. Right now, the Fed is in the driver's seat. We're waiting to see if they can slow to the speed limit or if they are going to slam on the brakes and send the economy through the windshield. A recession within the next two years may be unavoidable but it's not imminent.
  • I expected increased volatility during the first half of the year as market participants adjusted to changes in Fed policy. The war in Ukraine and the unexpected COVID-19-related lockdowns in China have added to the market volatility. With the coming mid-term elections, I expect elevated levels of volatility to continue into the Fall.
  • My reasonable range for the S&P 500 is to trade between 4000 and 5000 for the remainder of the year, ending with a positive or negative single-digit return.
I encourage you to avoid thinking in binary terms. There is a tendency to believe that the current trend will continue into eternity. When markets are rising, many think they will continue going up even in the face of data to the contrary. When markets decline, some feel that nothing good can ever happen again. Wars eventually end, supply chains will normalize, and inflation will moderate. I believe the best strategy is not to be in or out of markets but rather to adjust based on your goals, time horizon, and current risks.