Market Outlook: Is a Recession Coming? Or Is It Already Here?
Economic downturns and the fear of storm clouds rolling through the financial markets are on everyone's mind. So how do you keep your portfolio agile and protected against the threat of a recession?
Whether you're an aggressive investor looking for value or just trying to reduce your risk exposure during market uncertainty, Axos Invest Senior Vice President Tracy Gallman offers thoughts on the best positioning for your money through the rest of 2022.
Q: The last few months have been a real rollercoaster for investors with wildly up and down months as Wall Street flirted with a bear market before rallying. As we get deeper into the back half of the year, is 2022 proving to be one of the toughest investing landscapes ever for professionals to forecast?
A | Tracy Gallman
TG: Following the professionals is going to be an investor's best option in these choppy markets. The view of many professional money managers, analysts, and economists is that the macro fundamentals are changing in magnitude, not necessarily in direction. Investors may want to be rather tactical and selective in how they consider equities and fixed income exposures in their portfolio.
Investors continue to face a highly challenged macro backdrop. Inflation pressures, the ongoing Russia-Ukraine war, and recession fears are driving negative sentiment. Markets and rates have struggled to price in the growth/policy trade-off, swinging from recession fears and a less aggressive Fed to inflation fears and a more aggressive Fed.
While May brought a measure of stability with positive equity returns and lower rates, continued inflationary pressures in June increased pessimism and hawkish Fed expectations, leading to large drawdowns in equities and higher rates. Inflation is unlikely to show signs of peaking for another couple of months, which is likely to keep rates volatile and prevent equity markets from recovering.
That said, looking forward a couple of months, it's expected that the demand collapse that's already well underway and higher retail inventories could bring inflation relief. This, combined with slowing growth and tightening financial conditions, suggests the Fed may have to slow the pace of rate hiking later in the year. This would provide some support to both equity and fixed income returns.
Equities have struggled to find appropriate levels given macro risks and a lack of visibility around Ukraine and supply-driven inflation pressures. Entering the quarter, equities were underpricing risks. Now they're pricing the odds of a recession as a given. This, along with the outlook for growth, means investors might not have to be as defensive in the near-term.
Investors may want to consider tactical adjustments that make sense in a slower growth, tighter policy backdrop . This includes a higher dividend allocation, higher quality, and a larger underweight to Europe, where aggressive monetary policy is just starting to take hold and inflation is worse.
The demand destruction (a permanent shift in customer behavior fueled by high prices and low supply) was delayed by consumers flush with cash. But it's now taking hold and will result in falling core inflation in coming months. While rates are expected to remain volatile, a medium-term thesis is that the Fed will not get to where the market is currently pricing rates by year-end. It's anticipated the result may better returns for fixed income investors in the back half of the year. This is driven by higher yield carry and some rate relief by year-end (or at least no more rate increases).
Q: We've heard recession concerns floated for months and months … but we have yet to see consecutive quarters of declining GDP. Have we survived the worst of recession fears – or do we expect a true recession is still coming?
A | Tracy Gallman
TG: A handful of prominent forecasters cut estimates for second-quarter gross domestic growth. This shows they believe we're in a technical recession even while other economists foresee a return to growth.
The nation's economy was off by about 1.6% for the first quarter of 2022, then 0.9% for the second quarter. That technically qualifies this stretch as a recession since negative GDP growth was sustained across two straight quarters, although that isn't an official definition.
And storm clouds continue to circle. The Wall Street Journal found several economists significantly raised their odds of a recession in the next 12 months to just under 50%. Economist and subprime mortgage crisis bell-ringer Nouriel Roubini was even less optimistic, predicting a full-blown recession by year's end. And in a column for Bloomberg, former New York Federal Reserve President Bill Dudley estimated a recession was “inevitable within the next 12 to 18 months.”
All that said, many economists are still unconvinced the U.S. will fall into recession—at least not immediately. Analysts at S&P Global Ratings said the economy has enough momentum to avoid a recession this year, but warned “what's around the bend next year is the bigger worry.” The economists put the odds of a recession in 2023 at 40%. One week earlier, Morgan Stanley put the chances at 35%.
Whether or not analysts decide to call it a ”recession,” a slow growth environment seems likely. Investors will have to be flexible with their portfolios and look for opportunities in the equity and fixed income areas that benefit from these types of market environments.
Q: Considering our landscape is likely to remain rocky for the near future, what advice do you have for investors looking to take a more defensive stance in their portfolios?
A | Tracy Gallman
TG: Investors need to assess their tolerance for volatility and their appetite for loss. Depending on these factors, investors may want to be more defensive or tactical with their portfolios. Identifying exchange-traded funds (ETFs) that use risk management techniques like hedging or options may be useful tools. Or find a mutual fund that is more tactical, with the ability to move to cash or move in and out of sector or adjust for factor tilts. They may make sense to have in the portfolio to help reduce loss due to volatility.
Q: On the other side, there are some investors who are willing to take on more risk and be aggressive in this market by finding value in beaten down securities. But how aggressive is too aggressive right now – and is that a good approach to take?
A | Tracy Gallman
TG: Investors need to understand what aggressive is to them. Is it buying into lows? Is it being 100% invested in equities? Is it trying to “time the market”?
It's important to consider potential returns as well as your tolerance for risk. Investing all your money right away might yield higher returns than investing smaller amounts over time.
A strategy called dollar-cost averaging is a sound methodology for getting back into the market during volatility. When an investor uses this approach, they buy more shares of an investment when the share price is low and fewer shares when the share price is high. That way, you can end up paying a lower average price per share over time. By slowly going into the market as opposed to handing over your money all at once, dollar-cost averaging can help you limit your losses if the market declines.
Under that strategy, investors can take a more aggressive position, knowing they are slowly getting back into the market to take advantage of lower prices. Dollar-cost averaging can help take some of the emotion out of investing, compelling buyers to continue investing the same amount, regardless of market fluctuations, potentially helping avoid temptation to time the market.
An important note – investors who engage in this investing strategy may forfeit potentially higher returns. With dollar-cost averaging, you are holding onto your money as cash longer, which has lower risk. But this often produces lower returns than lump sum investing, especially over longer periods of time.
Q: We've heard rumblings that the Fed could be looking at more 50-basis point interest rate hikes, potentially even at every FOMC meeting for the rest of the year. Some investors get nervous when they hear talk like that. What can investors look for in relation to interest rates to better protect their portfolios?
A | Tracy Gallman
TG: It's highly likely that the Fed will continue to increase rates for the near future, with some predicting increases of another 100 to 150 basis points. In that type of climate, it's a good time to review all short-term investments and consider opportunities the rise in rates have created.
For example, there are better return opportunities on short-term Treasury bonds and certificates of deposit (CDs) right now than just a few months ago. Rates have increased for money markets and funds in bank accounts.
Another strategy for rebalancing your portfolio is selling asset classes that have held up best and buying those asset classes hardest hit. Once investors lower their potential year-end tax bill by selling positions showing losses, they can always replace these investments after 30 days (under the wash sale rule).
This move enables investors to offset the taxes owed on capital gains elsewhere in their portfolio. The result is that less of your money goes to taxes and more may stay invested and working for you.
Q: The personal savings rate was down to 4.4% in April, the lowest rate since the Great Recession in 2008. How can smart investors use their investments wisely to put money away for the future?
A | Tracy Gallman
TG: Commodities have outperformed all major asset classes during the four distinct periods of rate-hike cycles by the Fed in the past three decades. Commodity stocks are rallying, and they can be a way to inflation-proof your portfolio. Inflation has hit a 40-year high, and consumer prices are at an all-time high. Raw materials are scarce and inventories are down. Commodity stocks offer a chance for investors to capitalize on costs that are then often passed on to consumers.
In periods of rising interest rates and inflation, investors may want to consider high-quality and high-dividend-bearing stocks to best shield against the effects of downturn as well as offer additional regular income to help weather higher costs overall.
In this case, high quality stocks are generally companies who perform better during economic downturns. They historically are low on debt, deliver consistent earnings or dividends, and show reliable, steady growth over time while maintaining favorable balance sheets without being over leveraged.
Views expressed are as of August 15, 2022 and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author, as applicable, and not necessarily those of Axos Invest.
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While it's open to debate whether markets have already experienced the height of this period's uncertainty, the landscape is expected to remain volatile for some time to come. As always, all investors should continue to carry a diversified, balanced portfolio crafted to their specific economic goals as well as a plan for unexpected market events should they arise.
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