Evidence Mounts for “Light” Recession in Next 12 Months
As most know, my base case for the U.S. (and global) economic outlook for 2023 is calling for a light, income statement-oriented economic recession followed by a recovery period. It appears that the recession won’t be just a U.S. event. Other parts of the world will also experience various levels of economic growth contraction.
If a recession doesn’t occur, I think a continuation of the stagflation environment that we have experienced this year (positive but low GDP growth coupled with higher-than-desired inflation pressure) may unfold, an outcome I believe may be more damaging than a light, quick recession.
Why do I say this? A slow growth, high-inflation environment is damaging to all. Inflation tends to negatively affect the lower-income segment of society more so than the higher-income segment, so inflation tends to act as a regressive tax on a population’s real wealth and income.
Does this mean I’m cheering for a recession next year? Of course not. But a quick, light growth downturn should effectively wring a large amount of inflation pressure from our economy (it historically has as final demand tends to decline, bringing prices down along with it). The business cycle “clock” would be reset, setting the stage for a renewed period of economic growth and prosperity.
I also believe a credible case for a “soft landing” can be made, but history tells us when the Federal Reserve has entered a period of inflation-fighting, a period of monetary tightening, a hard landing has usually occurred. On September 21, 2022, Federal Reserve Chairman Jerome Powell stated, “The chances of a soft landing are likely to diminish to the extent that policy has to be more restrictive.” But the alternative is worse, he added, as reported in The Wall Street Journal. “A failure to restore price stability would lead to greater pain later on,” Powell said.
Want further proof? In my commentary last month, I highlighted the latest reads of our three business cycle timing tools, with two of the three now flashing red, indicating that a recession of some sort is likely next year. In the U.S. Treasury Yield Curve Spread chart, you will find one such read—that the 2/10 yield curve spread is now -50 basis points, showing the yield curve is the most highly inverted in 40 years.
I have been raising the probability of the economy entering a recession for some time now. Some are asking why we haven’t yet entered a recession. I’m enough of a monetarist in my economic leanings to believe the Fed’s policies affect overall final demand (and to a limited degree, supply) with a lag. Typically, when the Fed makes a monetary move, the effects on the general economy don’t take place for a six- to 12-month period.
With this in mind, we need to remember that the Fed didn’t start raising interest rates until April of this year, and that rate increase was a small 0.25%. This was followed in May with a 0.50% rate increase. It wasn’t until the June meeting that the Fed started to raise rates by 0.75% and continued at that pace for the three meetings following that June meeting. So, with the typical monetary lag effects, the “sharp slap” of monetary policy probably won’t be fully felt by the economy until sometime in the first half of 2023.
Keep in mind, some parts of the economy are already in recession. Housing starts are poor, as mortgage rates have risen dramatically. The recession has already started in that segment of the economy. Light recessions of the type I am anticipating tend not to dramatically affect all parts of the economy at the same time. Indeed, I’m not looking for a repeat of the recession of 2008-2009 when the economic trap door swung open, and everything was in trouble. This recession, if it occurs, will be of a different ilk than the earlier Great Recession.
Viewed from an economic perspective, recessions are part of the normal business cycle, a period of economic cleansing. Over periods of time, capitalism results in excesses. To explain, people have free will to do what they wish. This free will leads to excesses at times, where too much of something or too little of something else is present in the economic landscape. That is the reason recessions occur—a period where the economy can “reset” and cleanse the system of these imbalances.
According to the National Bureau of Economic Research (NBER), recessions have lasted an average of 11-12 months and tend to be the shortest of the four business cycle stages. Recessions are followed by a recovery period when economic growth tends to be robust. If we see a light recession unfold next year, I think this period of robust economic growth will occur later in 2023.
Recession Coming – Head for the Hills? Not!
Historically, stock-price change has been a front-runner of recessionary environments. Additionally, one of the drivers that shoves the economy into contraction is rising interest rates (as obviously is the case today). So, both stock and bond prices have tended to swoon prior to the start of recessions. By the time the economy is deep in recession and the NBER recognizes that, yes, we are in recession, stock and bond prices normally have tended to recognize the fact that a recession exists and have already started a new bull market.
Additionally, one reason the economy tends to recover from recessions is the Fed changes gears, re-liquifying the banking system by bringing interest rates down. These are driving factors that I believe we will see unfold later in 2023. By the time the recession starts, it is probably too late to run for the hills and sell stocks—most of the damage has already been done.
Want data? According to Ned Davis Research, on average, stock prices have declined a mere 3.8% over the first six months when the economy has been in recession (last 12 recessions). So, if one panics and sells stocks after the start of recession, that person has typically been selling stocks on the cheap.
Recession Investment Playbook
While speaking with clients and wealth advisors, I have received many questions regarding investment portfolio positioning—capital allocation considerations, if you will, when being faced with the high likelihood of an upcoming recession. Based on historical patterns, what may investors wish to consider? In answering this question, I risk stepping beyond my bounds as an economist and assume the daunting role of an asset allocator. But, along with our Chief Strategist Jeff Krumpelman’s great work in this area, I submit the following, with the caveat that these ideas may not be appropriate for your own circumstances. By working with your wealth advisor, you can determine whether these ideas are pertinent to your needs.
- Rule #1 in the recession investment playbook (based on historical standards) is to not sell risk-based assets following the start of the recession. By that time, valuations have normally already contracted and tactical risk-off trading may prove ill-timed.
- Rule #2 is to remain balanced. Most asset classes provide good returns coming out of recessions. Of course, some classes outperform others.
- Consequently, rule #3 is to have some exposure to bonds, as the Fed is typically busy bringing interest rates down in the later stages of a recession. Bond prices tend to perform well coming out of previous recessions. This includes the high-yield bond segment.
- Rule #4 is to start to look at U.S. small caps. Many of today’s investors haven’t focused significantly on U.S. small-cap exposure for good reason. It has been quite some time since small-cap stocks have outperformed large-cap stocks. Also, small-cap stocks have the return distinction of carrying a higher return standard deviation than their large-cap cousins. So, for the last 10 years, there has been little reason to carry an outsized position in U.S. small caps.1 The S&P 500 generated an average annual return of 13.00% versus the Russell 2000 Index annual return of 10.12%.
But if the economy enters a recession next year, investors may wish to initiate/add to existing small-cap holdings. Note the chart above, provided to us by Strategas. The Russell 2000 index (small-cap index) outperformed the S&P 500 (large-cap index) by 15%, on average, coming out of the last six recessions.
Evidence is mounting that we may indeed see an economic recession unfold over the next 12 months. Following recessions, capital returns tend to accelerate for most asset classes. Small-cap stocks have outperformed many other asset classes coming out of recessions, including large-cap U.S. stocks.
While it may be early to make a move into these riskier asset classes today, the time may indeed be approaching where moving capital into these classes to take advantage of an improving economic environment may start to unfold next year.
1S&P 500 and Russell 2000 Indexes, 11/30/12 – 11/30/22, Thompson/Reuters
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.
The Russell 2000 index is an index measuring the performance of approximately 2,000 smallest-cap American companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. stocks. It is a market-cap weighted index.
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