At the recent Jackson Hole Economic Symposium, Federal Reserve Chair Jerome Powell made it clear that the central bank remains focused on combating inflation despite recession signals rising in tandem. To wit:
"Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
- The Fed remains focused on lagging economic data, such as employment, which are highly subject to future revisions, and;
- Changes to monetary policy do not show up in the economy until roughly 9-12 months in the future.
There is little doubt we are amid an economic slowdown. With the Federal Reserve focused on combating inflation by tightening monetary policy, thereby slowing economic demand, logic suggests that economic data trends will continue to decline.
As the Fed continues to hike rates, each hike takes roughly nine months to work its way through the economic system. Therefore, the rate hikes from March 2020 won't show up in the economic data until December. Likewise, the Fed's subsequent and more aggressive rate hikes won't be fully reflected in the economic data until early to mid-2023.
Given the Fed manages monetary policy in the "rear-view" mirror, more real-time economic data suggest the economy is rapidly moving from economic slowdown toward recession. The signals are becoming more apparent, as shown by the six-month rate of change in the Composite Index of Leading Indicators.
NFIB SurveySmall business sales are the lifeblood of the economy. We have written previously about the importance of small businesses relating to employment, incomes, economic growth, and even the stock market.
For example, overall confidence expressed by the members of the NFIB owners is at levels historically associated with deep recessions and bear markets.
Since small businesses drive the economy, employment, and wages, what the NFIB says is highly relevant to the actual economy. Furthermore, their "confidence" in the economy is critical to the ongoing support of employment, capital expenditures, and wages. As shown, the economic view of NFIB members over the next six months has plummeted to record-low levels. This does not bode well for additional employment, capital expenditures, or increased wages.
CEO ConfidenceThe Conference Board Measure of CEO Confidence, in collaboration with The Business Council, declined for the fifth consecutive quarter in third quarter 2022. The measure now stands at 34, down from 42 in the second quarter. The measure has fallen deeper into negative territory, to lows not seen since the start of the COVID-19 pandemic in 2020, but consistent with prior contractionary periods. (A reading below 50 reflects more negative than positive responses.)
According to the the Conference Board, “CEOs are now preparing for the near-inevitability of a U.S. recession by year-end or in 2023.”
Given that corporate revenues and earnings are derived from the consumption by individuals, it should be no surprise that there is a high correlation between the CEO and Consumer Confidence Composite indexes. As the economy weakens, CEOs will try to retain a level of employment as long as possible, until they eventually must reduce their workforce. This is why there is a lag between the consumer confidence composite and the CEO survey. However, that lag is a pre-recessionary indicator and currently suggests the risk of an impending recession.
Yield-Curve InversionAs noted above, both indicators are warning of a recession—and both have near-perfect track records.
However, yield-curve inversions are another indicator with a near perfect track record of predicting recession. Currently, 50 percent of the 10 spreads we track are inverted. As such, it is worth paying attention to the data. If the number of inversions increases, such will confirm that a recession is more likely. However, and crucially, the inversion is only the warning of a recession. When the yield curves "un-invert," such will be the recognition of the recession. This will occur as money shifts from short-term risk assets to the safety of long-duration Treasury bonds.
Crucially, as the Fed hikes rates, more curves will invert.
Most important, with economic growth slowing rapidly, inflation running at the highest levels since 1980, and consumers tapped out, recession risk is likely higher than many realize.
Preparing for a Policy MistakeFrom our perspective, the risk of recession remains elevated, particularly as the Fed aggressively hikes rates and restricts monetary accommodation.
- Raise cash levels in portfolios.
- Reduce equity risk, particularly in high-beta growth areas.
- Add or increase the duration in bond allocations, which tend to offset risk during quantitative tightening cycles.
- Reduce exposure to commodities and inflation plays as economic growth slows.
Alternatively, it is relatively straightforward to reallocate funds to equity risk if we avoid a recession or if the Fed does revert to monetary accommodation.
- Have excess emergency savings so you are not "forced" to sell during a decline to meet obligations.
- Extend your time horizon to five to seven years, as buying distressed stocks can become more distressed.
- Don't obsessively check your portfolio.
- Consider tax-loss harvesting (selling stocks at a loss) to offset those losses against future gains.
- Stick to your investing discipline regardless of what happens.
But, if I am correct, we have more work to do first.