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What is a Recession and Why a Recession Matters

What is a Recession and Why a Recession Matters

We have experienced quite a start to the year. The equity markets have had a difficult start to 2022, with the S&P 500, the Dow Jones Industrial, and NASDAQ all seeing double-digit losses. Many of the bond indexes have seen historically bad beginnings to the year as well. The year-to-date losses in the equity and bond markets, coupled with rising inflation rates and a persistent war in Ukraine, have greatly increased the likelihood of a recession. As a result, we have seen the term recession take center stage in many new headlines and broadcasts. Let’s take a closer look at recessions and how one may impact the economy and markets for the remainder of 2022. 

Defining a Recession

The most widely accepted definition of a recession is two consecutive quarters of negative economic growth, as measured by GDP. However, more recently, the description has expanded to include other economic criteria, including depth, diffusion, and duration. The National Bureau of Economic Research has a definition that is more flexible because no two recessions are the same, therefore, a broader interpretation makes sense. One recession may be caused by a shake-up in the labor markets while another may be due to an unexpected shift in the economy such as the housing market crash in 2008-2009 or a non-economic factor such as a pandemic. Hallmarks of a recession typically include companies missing on earnings projections and negatively adjusting future forecasts, consumers curtailing discretionary spending, and a feeling of overall uncertainty that can become palpable. 

 

Why Does It Matter So Much?

The reason why recessions matter so much to economists is that they indicate the slowing of an economy and can lead to many negative consequences such as job losses, companies going out of business, and prolonged stock market volatility. Recessions create an unpredictable economic environment. Once a recession has started, it is very difficult to determine how long it will last or how much damage it will do. We typically see the adverse effects of a recession before economists are able to officially say we are in a recession. We may very well be experiencing some effects in our current economic situation. The economy did contract in the first quarter of 2022, with a GDP drop of 1.6% annualized. We likely won’t know the final GDP growth or contraction rate in the 2nd quarter until late September; however, many of the domestic and international stock indexes are already reacting as though we are in an economic slowdown. One thing is becoming abundantly clear – the driving force behind the current economic slowdown is the return of inflation. We haven’t seen inflation levels this high since the early 1980s. If inflation persists into 2023, it will likely have a negative effect on consumer spending as well as overall consumer sentiment.    

What To Do As An Investor?

The pressing question for investors navigating through a recession is how to protect their investment portfolio. The most prudent answer to the question is diversification and patience. Since WWII, the average recession lasted roughly 11 months. Conversely, the average bull market lasts roughly 2.7 years. A well-diversified portfolio that matches the investor’s risk profile will give the best chance for long-term gains, even taking the losses of a down market into consideration. Assuming a well-diversified portfolio is in place, the most critical variable is the behavior of the investor. This is because staying invested through down markets takes resolve and fortitude, it is not for the faint of heart. Seeing monthly statement after monthly statement filled with negative numbers can cause even experienced investors to make questionable decisions. Remember, recessions are part of an economy’s natural cycle, not a deviation from it.    

AUTHOR

Nate Condon

Nate Condon

Financial Advisor

Nate Condon is one of the co-founders and managing partners of Walkner Condon Financial Advisors. He is a fee-only, fiduciary financial advisor who works with clients locally in Madison and around the country.

It Only Gets Harder from Here: Valuations, Bond Environment and Wage Growth

It Only Gets Harder from Here: Valuations, Bond Environment and Wage Growth

If we look back at the stock and bond markets with a Monday Morning quarterback lens post-2008 financial crisis, one has to consider if the “easy money” has already been made. It’s almost hard to believe that the historically good run in equity markets has also been coupled with a favorable bond environment as well, with returns looking very solid net of inflation through many portfolios. The simplicity of this gain also bears noting  – if you simply bought the S&P 500 and coupled it with an aggregate bond strategy solely based in the United States, you did very well for yourself.

Note: SPY used for S&P 500 index proxy, AGG for aggregate bonds, DBC for commodities, EFA for international developed companies, and VWO for emerging markets. 

Naturally, we can ascertain from this chart that it hasn’t been a totally smooth ride from the equities perspective, but it is also safe to say that stocks have pretty much acted as stocks should. It also should be noted that a globally diversified portfolio detracted from your gains over this period compared to a solely U.S.-focused one. 

Looking forward, as we digest both the longer-term past as well as the last 12 months, some headwinds are developing that may affect the future of our portfolio management. Some of these will be more fleshed out in the remainder of our commentary, as they bear a deeper dive. 

Here are three of the main challenges we see as we go forward.

Stretched Valuations, Particularly in U.S. Equities?

Generally, the thoughts we get from many of our clients is that the U.S. stock market is overvalued. Over the last year, however, many may not realize that the “overvaluation” of the market 12 months ago was even more pronounced than it is today. See this price to earnings ratios (P/E) chart since 2017:

Note: This is the S&P 500 index price to earnings (P/E) ratio.

Why did this occur? Simply speaking, the earnings of companies ended up catching up while revenues remained strong due to waning COVID lockdown measures coupled with unprecedented government stimulus. Treating 2020 as somewhat of an outlier due to COVID factors, today’s P/E ratio remains elevated relative to the last 10 years. 

The question remains whether this elevated P/E ratio actually signals that the U.S. market is overvalued. There are several factors that come into play – low interest rates with expected interest rate increases, pension and institutional wealth funds trying to hit rate of return targets, inflation expectations, and many others. These factors when coupled together paint a much more complex picture of the “why” concerning elevated P/E. But in the end, we will continue to need strong earnings to support higher prices. In 2022, we see more headwinds due to an anticipation of higher rates, potentially pouring some cold water on the inflation heat and possibly slowing growth as a result. We also believe that there should be tailwinds – at some point, we will emerge from COVID, leisure activities and travel will increase significantly, and taxation on businesses and individuals will likely remain low until at least 2025 absent any unexpected legislation. 

Low-Interest Rate Environment Matched with Expected Low Returns in Bonds

The Fed has been quite transparent about its plans to raise interest rates throughout 2022 in a response to inflationary pressures and potential overheating of the U.S. economy. While we have been through a long-term decline in interest rates over the last thirty years, there have been periods of time where interest rates have been on an upward trajectory, albeit relatively short ones. One more recent period of time where this occurred was in 2018 when the 10-year treasury rate increased over 12%. In looking at how this increase in rates affects bond prices and yields, we can reference the following chart:

Note: BND used to represent the total bond market, BSV used to represent short-term bonds.

Some takeaways from this:

    • The 10-year treasury did not move in a straight line during the year. Despite this, dividend yields from the two ETFs (used as examples), steadily climbed throughout much of the year.
    • As yields climbed, prices fell, which is the conventional wisdom we learn in economic textbooks. Keep in mind that the 10-year treasury started in the 2.5% range in 2018 and crested over 3%. We ended 2021 with a rate of around 1.5%. Here is a data source for treasury rates.
    • Short-term bonds weathered the higher interest rates better than longer-term bonds, which again would fit conventional wisdom. Additionally, shorter-term bonds were less volatile than longer ones during this period.

As we look at 2022 and beyond, we expect interest rates to keep climbing throughout the year, though it is unlikely the climb will be in a straight line. One strategy to employ for the year would be to keep the duration of your bonds short if interest rates do indeed rise, and perhaps consider using some inflation-protected bonds if you expect inflation to continue to remain high. The issue with that is we are starting from a very low-interest rate – the 10-year treasury (which would be considered intermediate bond duration) is still well below 2% at the time of this writing in early January. As rates rise, bond prices will fall, so it is highly unlikely we will see much in the way of gains.

Another strategy is to move into higher-yielding bonds – perhaps considering lower credit quality or floating rate bonds to juice up yields. The issue with going too far down that path is simply that a decrease in credit quality will lead to taking higher risk in your overall portfolio, and aren’t bonds supposed to be your hedge against falling stock prices and your way to diversify? 

If you are gathering from the above comments that this is a tough environment for bond investors, you would be correct. Starting from such low yields, historically speaking, with the prospects of increases in interest rates, would portend a less than rosy outlook for bonds in the near future.

Uncertainty of Wage Growth

Nearly 70% of our GDP measurement ends up coming from consumer spending. When we emerged from the depths of the pandemic, as states started to reopen, there was a significant shortage of workers to fill job openings. Resultantly, we saw a significant increase in wages that persists today (and at the bottom of the wage ranges, this started before COVID). This is the good news. 

The bad news is this is only one side of the equation, as we care more about “real” wage growth, defined as wage growth minus inflation. Unfortunately, we have seen inflation quickly overwhelm wage gains. As we all have felt the higher prices at the pump and in our grocery stores, we all hope these will be temporary

If Americans are feeling the effects of inflation, several things could happen:

    • Purchases could be delayed or canceled due to the increased costs of items.
    • Substitutions could be made to minimize the impact of price increases, for example, instead of buying the organic strawberries you choose to buy non-organic or you substitute pork for beef.
    • Purchases are accelerated with the thought that prices will be higher in the future. For example, ordering countertops from Home Depot now instead of waiting a few years.

Aside from the accelerated purchases, cancellations or substitutions will be negative for GDP growth. Additionally, the greater wage uncertainty one has, the less “risk” they are willing to take when making purchases. If “real” wage growth isn’t so real, despite the likely outcome of prices being higher a few years from now, a family may not choose to buy a home, automobile, or other higher-priced items just based on the perception that they won’t be able to maintain their purchasing power. 

So What Does This Mean for 2022?

We don’t believe in producing a market forecast, as it is a fool’s errand. What we will posit is that we expect greater volatility, as the first few days of 2022 would indicate, while returns may come a bit harder than 2021. As it stands, to score runs right now we may have to settle for some small ball and lots of singles – for those baseball fans out there. For advisors, it means that we have to remain open to considering investments beyond the S&P 500, as we always have. In any market, there will always be opportunities. Perhaps this can be found in considering a rotation towards value-oriented U.S. stocks, a more substantive allocation to non-U.S. stocks, or potentially, more tangible assets such as commodities or real estate. In the end, we all must remember that time frame and time in the market are inherently crucial to long-term success, so review these items with your advisor in your strategy meetings to see how it applies to you specifically.

Clint Walkner

2022 Investment & Market Outlook Guide

Clint Walkner’s piece is part of Walkner Condon’s 2022 Investment & Market Outlook Guide, a comprehensive reflection of 2021 and glimpse at the factors impacting the year ahead in 2022.