Market Perspective: Managing Recession Fears

Monetary policy adjustments have arrived and brought with them a fresh set of recession fears. The Federal Reserve is aggressively tightening policy by signaling an increased pace of rate hikes and significantly reducing the size of their balance sheet. Caution is warranted since the past 13 rate-hike cycles have resulted in 10 recessions. The odds of the Fed delivering the proverbial economic “soft landing” are not great.

The Fed is in a challenging environment with real economic growth slowing while inflation continues to be a concern. Recent payroll employment numbers were strong, which does not help the inflation picture. At the same time, companies such as Tesla, Microsoft and JP Morgan are issuing warning signals.

The market expects the Federal Reserve to increase short-term rates to 3%, or by an additional 2%, prior to the year-end. The bond market is now mostly prepared for the increase as the 2-year Treasury yield hovers near 2.70%, up from 0.73% at the beginning of the year.

Typically, the best forward indicator for weighing recession risks is capital market pricing. Earlier this year we observed a yield curve inversion, when the 10-year yield was higher than the 2-year yield. And the S&P 500 declined for seven consecutive weeks ─ the first time since 2001 and only the fourth time since 1970. Markets seem to be discounting recession chances in the 30% to 40% neighborhood over the next 12 to 18 months, if not sooner.

The inflation conundrum

What’s different today versus prior rate-hike cycles? The key difference is the persistent inflationary environment.

The market has become accustomed to the Fed reversing tightening policy based on instability in the stock market. This has been termed the “Fed put.” Low inflation during the last 20 years allowed the Fed to maintain easy policies. However, today’s high inflation expectations mean stock market volatility will not impact the Fed’s tightening plan unless inflation expectations also come down.

Some voting members of the Federal Reserve, including Lael Brainard and Loretta Mester, have voiced the need to continue raising rates. Rates “will probably need to go above its longer-run neutral level to rein in inflation,” Mester said.

What can you do?

Tech-heavy exposures are well into bear-market territory, whereas more value-oriented strategies have suffered only minor corrections (Energy and Utilities are the only two sectors with positive returns this year). For our clients, healthy allocations to diversifiers, defensive equities and value equities, while being underweight to growth equities and fixed income, have provided protection in their portfolios. This is also a good time to harvest losses for valuable tax savings.

Pessimism and volatility are higher than in recent history ─ which tend to lead to fear and emotional investing. Diversified portfolios may help you to be patient, maintain discipline and stay focused on the long-term while avoiding the impulse to make portfolio changes in a desperate attempt to sidestep short-term volatility.

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