Are We Going Into A Recession

The past two weeks have seen a steep decline in the stock market on the fear of rising rates and an impending recession.

It’s still higher than the lows of June, but after a brief rally over summer the stock market has again turned downward.

The Consumer Price Index (or CPI) numbers, a standard measure of inflation, came in at 8.3%. Everyone was expecting 8.1% and the fact that they were a smidgen higher means the Federal Reserve isn’t succeeding at curbing inflation. This means that Jay Powell, chairman of the Fed is likely to announce another 0.75% to 1% rate hike next week.

This spooked the market.

If that wasn’t enough bad news, FedEx revised its earnings estimates significantly downwards for the rest of the year, citing a global slowdown in demand. It’s closing 90 offices worldwide and likely will be laying off staff.

Many people view FedEx as an indicator of the global economy. If FedEx is slowing down, it must mean the global economy is also slowing down.

As scary as these sound, neither of these things is set in stone.

Even though inflation isn’t as transitory as we originally thought, it seems to have peaked and is declining, even if quite slowly. Oil and commodity prices have subsided, supply chains are opening up, demand is softening, used car prices have started to come down, and asking rents have started to drop as well.

And FedEx’s track record of predicting its annual earnings is terrible.

Over the past decade, it has lowered its forecast at least once in 9 of the years, sometimes soon after raising it. It also runs a dual delivery network consisting of both employees and contractors, unlike UPS which only hires employees. This makes for inefficient and complex scheduling, especially during times of high employee turnover, such as we now face. Compared to its competitors, FedEx is more dependent on global trade for growth. Considering we’re now past peak globalization, FedEx’s best days are likely behind it. This speaks to operational issues, and not necessarily macroeconomic ones.

Also, we know that the pandemic brought forward future demand as consumers sat at home and spend all their discretionary income on home goods, furnishings and renovations. And now the world has opened up again, the consumer has replaced goods with services. They are spending more money on restaurants, concerts, and travel.

As a confirmation of this trend AirBnb’s CEO recently reiterated they are having a record year. Bookings and Average Daily Rates have exceeded pre-pandemic levels. They are generating billions of dollars in free cash flow and have even instituted a share-buyback plan.
This sentiment was shared by airlines like SouthWest and Delta as well.

But while the prices of goods and energy are declining, the cost of services is not.

If inflation doesn’t get under control, the Fed will continue to raise interest rates. At the current rate of decline, inflation won’t get under 4% until March and under 2% until May.

We can expect the Fed to continue to raise interest rates over the next 6-8 months. It already raised 0.75% this week and I anticipate a few more rate hikes after that.

If you are worried and confused by all these conflicting data points you are not alone.

All major banks have differing views on what the next 6-12 months hold for the economy. They are split between a severe recession, a mild recession, and no recession, but instead a period of very slow growth. Between them, they’ve covered all the outcomes.

Bank of America is projecting a recession beginning of 2023.

Goldman Sachs is currently projecting GDP growth for 2022 at 0% and for 2023 at 1.1%. They are in the mild growth camp.

Regardless of what happens to the economy, the stock market is likely to stay extremely volatile over the next 6 months.

So what happens if we see a recession? How do invest in such an environment?

First of all, remember the stock market is forward-looking. We don’t know if it has already priced in a recession and has bottomed out already. If so, the market might not revisit its June lows regardless of what happens to the economy.

The last time investor sentiment was this negative was in April 2020 and March 2009. In both cases, the stock market had already bottomed and traded higher after that.

S&P500 is already down 20% year-to-date and the Nasdaq is down 30%. Even if the stock market drops further from here, it’s unlikely to fall more than 10% or 15%. In order words, the worst of the decline is behind us.

The strong US Dollar has hurt foreign stocks. As foreign countries start to raise their interest rates, those currencies and consequently their stock markets will see a rebound. Foreign stocks are already quite cheap, trading for 10-11 times earnings, and sporting a 4% dividend yield. With a 4% dividend, we’re getting paid to wait for the eventual rebound.

These are much cheaper valuations than US stocks, which trade for 17-18 times earnings with a 1.8% dividend yield.

We continue to maintain our global diversification, focusing on companies with low valuations, healthy balance sheets, and strong cashflows. These will weather a recessionary environment.

If you’ve been buying speculative technology companies with high valuations and poor cashflows, you’re already down 35-70% over the past year and it’s time to start seriously reconsidering your investment strategy.

Rising interest rates cause bond prices to decline. They have already declined 13% this year. Long-term bonds have lost a whopping 26% this year.

On the bright side, yields on Treasuries and CDs are now higher than they have been in over a decade. Three-month Treasury bills now yield 2%, and I just saw a 10-month CD yielding over 4%.

Properly positioning your portfolio with short-term bonds that are less affected by rising interest rates will provide a buffer against declining stock prices.

Other than that, you should use a stock market decline to do these five things:

1. Reevaluate your holdings and restructure your portfolio
2. Use tax loss harvesting to save on your taxes
3. Exchange out of concentrated stock positions
4. Perform Roth Conversions
5. Exchange mutual funds for tax-efficient ETFs

As always, keep calm and stay invested. The worst is likely over despite the volatility of the next several months.

If you want to discuss your portfolio or any of these five topics, feel free to drop me a line or book a meeting.

Regards,
Nirav