Straight Talk on Recession Risk – What We’re Seeing & Doing

In May, we published a commentary discussing the economic and market environments. Inflationary pressures and tighter Federal Reserve policy were slowing economic growth, but inflation appeared to have peaked in March. The economy seemed to be headed for a “soft landing” rather than a recessionary “hard landing.”

In recent weeks, however, the May Consumer Price Index (CPI) report indicated that inflation had not peaked.  The Federal Reserve responded to this news with a 0.75% interest rate hike (the largest single-meeting hike since 1994) and clear guidance that they were willing to stifle economic growth to normalize inflation. All of this indicates a rise in economic risk in the coming months.

Economic Warning Signs – What Has Changed Since May?

In May, we published a table detailing some of the traditional warning signs of a recession, as well as whether or not each sign was evident. Please find this table with an updated column of the most recent economic data below.

Recession Warning SignIs This Happening? (May Commentary)Is This Happening? (Now)
Initial unemployment benefit claims are increasing.No. Initial claims are only marginally above their multi-decade low registered in mid-March.Yes, but slowly. Claims have increased from approximately 175,000 per week in March to 230,000 per week in June.
New manufacturing and service orders are falling.Too early to call. Recent business surveys conducted by the Institute for Supply Management (ISM) indicate a decline in new orders, but it is too early to declare a negative trend.Yes. The latest ISM and Philadelphia Federal Reserve manufacturing surveys indicated accelerated declines in new order flow.
Housing building permits are decreasing.No. The number of issued building permits has reached its highest level in the past sixteen years.Yes. Since March, the number of new permits issued has declined by 9.6%.
Stock prices are falling.Yes. The S&P 500 Index is down nearly 20% year-to-date, while the technology-heavy NASDAQ Composite is down nearly 30%.Yes, no changes here.
The interest rate difference between riskier bonds and Treasuries (the spread) is increasing.Not enough to be concerned about yet. The spread has increased, but not more than during the corrections of 2011, 2016, and 2018, and considerably less than during the global recessions of 2007 and 2020.Yes. Spreads continued to widen in June, affirming a further acceleration in the cost of borrowing for corporations (riskier bonds).
The difference between short-term and long-term interest rates is decreasing.Yes. At the beginning of April, the yield curve was “inverted,” indicating that short-term rates exceeded long-term rates. This is a recession warning sign, but it typically has a lead time of at least a year.Yes. The yield curve inverted twice more, reaffirming the risk of a recession.

In addition, WELLth’s four-pronged proprietary system for identifying periods of economic and market turmoil is indicating an elevated risk of market volatility over the intermediate term.

Big R or Little r?

Not all recessions are created equal. During the eight-month recession of 1990-1991, for example, the unemployment rate increased by only two percentage points, while the stock market fell by only 18.6% (a little “r” recession). In contrast, the unemployment rate increased by roughly five percentage points during the 1973-1975 and 2007-2009 recessions, while the S&P 500 fell by more than 50% (big “R” recessions). In our opinion, the severity of a recession is dictated by the severity of the economic shock. The current economic shock is runaway inflation, which has been recently exacerbated by the war in Ukraine and ongoing breakdowns in the global supply chain. We believe that the longer the war and supply chain issues continue, the greater the risk of a big “R” recession developing. Unfortunately, we don’t possess a crystal ball that can predict when Russia will leave Ukraine or when supply chains will normalize. Instead, we act based on what we know today – that current economic circumstances are historically associated with weak economic growth and reduced investment market returns.

What We Are Doing

Earlier in the year, we began reducing the aggressiveness of our strategies by upgrading the credit quality of the bonds we own for our clients. Some strategies that were overweight more cyclical sectors, such as technology and consumer discretionary, have been reworked to include more stocks in the defensive healthcare and consumer staples sectors.

Last week, we reduced portfolio stock allocations slightly, focusing primarily on “small-cap” stocks, which tend to be more economically sensitive than stocks of larger companies. Taking everything into account, a portfolio consisting of 60% stocks may soon contain 50% stocks. The sale proceeds were invested in US Treasuries, a traditional “safe-haven” investment.

Final Thoughts: Why Not Sell Everything & Move to Cash?

We are long-term investors and have the utmost confidence in the ability of stocks and bonds to deliver impressive long-run returns. Furthermore, we assume that periodic recessions occur when creating an individual’s long-term investment allocation. In other words, turbulent economies or markets are already considered when creating your portfolio and financial plan.

While we are 100% confident in the ability of stocks and bonds to generate long-term wealth, our short-term “tactical” moves are based on probabilities and precedent – the future is uncertain. While improbable, Putin could withdraw from Ukraine tomorrow, triggering a new bull market and quenching global inflation. We wouldn’t want our clients to be sitting on all cash as the markets soar. To summarize, we view our tactical portfolio shifts as modest augmentations and risk-reduction tools to our core long-term investment strategies.

As additional economic data becomes available over the next few months, you can anticipate hearing from us again. Please contact us at (561) 972-8011 if you would like to discuss your investments, financial plan, and what else to expect if a recession develops.

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