Anatomy of a Recession

By Andy Burnett, CFA

Five years ago, I wrote an article for CityScope® about investing during periods of global unease. At the time, tensions between North Korea and the United States were rising, a populist wave was spreading across the Western world, and deflation was a much bigger concern than inflation. Times have changed. On June 13, the S&P 500 closed below -20% YTD, signaling the start of a new “bear market.”

What happened? How do we recover? How should we adjust to these new market conditions?

I believe the primary drivers of this bear market are:
 

  • Price inflation, which has caused the Fed to begin raising short-term interest rates. Additionally, the Fed has begun to wind down its bond buying quantitative easing program.
  • Commodity shock, triggered by the sanctions levied against Russia for invading Ukraine.

Excess Stimulus, Excess Inflation

During the COVID-19 pandemic, the government passed a series of economic stimulus packages that rapidly increased money supply within the United States. These packages, specifically the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the Consolidated Appropriations Act (CAA), and the American Rescue Plan Act, added approximately $5 trillion dollars to “M2” money, a measure of the cash people hold in checking accounts plus “near money” like savings deposits and money market securities. These stimulus packages essentially put cash directly into consumers’ pockets at a time when the U.S. service sector was hobbled by forced lockdowns and reopening limitations. Consumers chose to redirect spending of their stimulus cash into purchasing goods over services and put massive strain on global supply chains. This ultimately led to inventory shortages and delivery bottlenecks, putting inflationary pressure on prices (more dollars chasing fewer goods). Initially, the Fed (and many others, myself included) thought this price inflation was transitory and would quickly work its way out of the system as the service sector came back online and supply chains recovered. Today, the service sector still hasn’t recovered to pre-pandemic levels, and global supply chains are proving more fragile than initially expected.

 

Growth in M2 Money Supply

Growth in M2 Money Supply

Now that it’s clear inflation isn’t transitory, the Fed has reacted by raising short-term interest rates. Raising rates increases borrowing costs for both consumers and businesses with the intention of slowing demand for debt and reducing asset price growth. Rising rates tend to hurt financial assets like bonds, due to their fixed payment structure, and stocks, since a component of a stock’s price is the estimated present value of future profits discounted at a business’s “cost of capital,” which generally increases when rates increase. As a consumer, higher financing costs coupled with potentially lower retirement account values can weigh on sentiment and ultimately lead to reduced spending.If the Fed manages to raise rates enough to lower inflation while only marginally chilling aggregate demand, it will have achieved its goal of a “soft-landing” for the economy. If it overshoots, it’s possible the country may fall into a recession. If it undershoots, inflation remains elevated and continues to erode consumer wealth. It’s a difficult task.

 

Russian Commodity Shock

The Russian invasion of Ukraine is a “black swan” event for investors. The Western world has now mostly turned its back on Russia, imposing strict economic sanctions, freezing the country’s foreign currency reserves, and striving to dramatically reduce imports of its commodities. These measures will undoubtedly negatively impact the Russian economy, with the World Bank predicting a staggering -11.2% contraction in Russian GDP in 2022.

While Russia is less connected to global value streams than other large nations (e.g., China), it’s a large exporter of commodities, such as oil, natural gas, fertilizer, grains, and precious metals. Russia is the single largest exporter of wheat in the world and the second largest exporter of cobalt. Additionally, Ukraine is a large exporter of agricultural cereal commodities such as sunflower seeds (and oil), soybeans, and rapeseed. The potential loss of Russian and Ukraine commodity supplies due to sanctions and war has put upward pressure on commodity prices across the world, inflating food costs and increasing fuel prices. There’s never a good time for war to break out, but this commodity shock adds inflationary pressure to already increasing prices from excess stimulus and goods/services consumption imbalances.

 

History of Bull & Bear Markets

History of Bull & Bear MarketsHow Do We Recover?

In short – reduce inflation, reduce commodity prices. In my opinion, the Fed’s strategy for reducing inflation should err on the side of short-term pain for long-term gain, being more aggressive with rate increases now. Aggressive rate increases may trigger a recession, but without taking the risk, it’s possible that markets may continue to trend downward for an extended period. The longer inflation persists, the more the Fed will raise rates, so more pain now may mean a quicker end to the rate-hiking cycle and provide the market a chance to recover. The global economic outlook is also important to consider when predicting the timing of a recovery, as many U.S. companies are highly globalized, and the countries they do business with are dealing with their own elevated levels of inflation as well.

It’s taken roughly a year for the market to reach the bottom during the last 13 bear markets, with an average drawdown of -32.1% and an average length of 11.3 months.

Investors today must now make the difficult decision to reposition their portfolios for the years ahead. Traditional portfolio allocation norms – like owning 60% stocks, 40% bonds – are proving to be ineffective in hedging downside risk. Bonds are performing poorly in the rising rate environment and have become highly correlated with stocks, reducing their volatility-minimizing qualities.

When considering a portfolio reallocation, first consider your investing time horizon. If your time horizon is greater than 20 years, you should still likely be invested in all stocks with a tilt toward growth stocks. If you’re closer to retirement and own bonds in your portfolio, consider selling intermediate and long maturity bonds (perhaps 10-15% of your current allocation) and instead buy a mixture of shorter maturity bonds, commodity funds, and real estate funds. With stocks, consider selling high-growth stocks (perhaps 5-10%) and buy more value-oriented dividend paying stocks. Businesses with good cash flow and profitability become more valuable in rising rate environments.

Remember that volatility is the price an investor must pay to gain wealth, and downturns are part of the investing journey. Stay informed and be patient, making smart tactical changes to your portfolio, and you will achieve your financial goals! 

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Andy Burnett is a Partner with Round Table Advisors and Senior Financial Advisor with Raymond James Financial Services. He holds Series 7 and 66 licenses, as well as the Chartered Financial Analyst (CFA) designation.andy burnett

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Andy Burnett and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.

Investment advisory services offered through Raymond James Financial Services Advisors, Inc. Round Table Advisors is not a registered broker/dealer and is independent of Raymond James Financial Services. Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC.

 

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