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It’s normal to be concerned about your investments given the current situation of the world right now. Over the past few weeks, I have received a few questions around risk that I believe merit further exploration.
These questions highlight the perspective that we will have a major correction / recession, and therefore, why not completely exit the markets? Many of these questions are based on the logic from my last article which highlighted the amount the Fed has printed, the Feds’ desire to raise rates, and fiscal tightening, all happening concurrently. In fact, it is notable that the Fed has not yet raised rates, but the 2-year yield has moved sharply higher, from 0.25% in September to 1.56% as of March 7th.
Therefore, it is clear that the Fed has already begun tightening and is well underway in the form of a reduction of incremental purchasing. Below is the progression on that front:
- November 2021 – $80B Treasuries & $40B Agency MBS ($120B net purchases)
- December 2021 – $70B Treasuries & $35B Agency MBS per month ($105B net purchases)
- January 2022 – $60B Treasuries & $30B Agency MBS per month ($90B nets purchases)
- February 2022 – $40B Treasuries & $20B Agency MBS per month ($60B net purchases)
- March 2022 – $20B Treasuries & $10B Agency MBS per month ($30B net purchases)
And this week, the Fed will make its final asset purchases (well at least for now). Using the research from the start of quantitative easing, this impact is roughly the equivalent of raising rates 6 times to approximately 160bps. Once this rate increase works its way through the markets, it will be clear that we are much further along in the process than we thought. Again, this is why we think the US economy cannot handle more than 2-4 interest rate hikes before facing larger headwinds. Nevertheless, we anticipate that in less than 2 weeks from now, the Fed will implement their first-rate hike.
We expect fiscal tightening in the months of March and April. The analysis of the fiscal budget remains the same relative to last December when the Build Back Better plan failed congress support. There are no PPP loans, no airline bailouts, no stimulus checks, no extended unemployment, etc. Essentially, there has been no additional big spending as of yet. This could potentially change, but it looks like a long, uphill battle to get anything done in Congress.
The bigger red flag in our model is in the details around inflation. Specifically with commodities prices, oil has shot up 27% YTD. Any large or rapid increases in oil pricing has been strongly correlated to be followed by a deeper correction. My concern is twofold: first, the average consumer is seeing prices continue to increase which will potentially limit spending capacity; second, year-over-year earnings from companies will be hard to meet or beat looking forward. Both of these two data points described above lead to serious headwinds in the economy. Below is some historical inflation- adjusted data, specific to oil price increases and recessions:
- 1947–1948 – Oil prices rise sharply ($20 to $30). Recession 1949.
- Apr 1953–Jun 1953 – Oil prices rise modestly, though rapidly. Recession 2H53 – 1H54.
- Jan 1957–Apr 1957 – Oil prices rise modestly, though rapidly. Recession 2H57–1H58.
- Jan 1969–Apr 1969 – Oil prices rise modestly, though rapidly. Recession 1970.
- Jul 1973–Jan 1974 – Oil prices rise sharply ($20 to $60). Recession 1974.
- Jan 1979–Apr 1980 – Oil prices rise sharply ($60 to $135). Recession 1H80 & again 2H81–1H82.
- Jun 1990–Sep 1990 – Oil prices rise sharply ($40 to $80). (Gulf War) Recession 2H90.
- Nov 1998–Nov 2000 – Oil prices rise sharply ($20 to $55). (Dot.com Bust) Recession 2001.
- Jan 2007 – Jun 2008 – Oil prices rise sharply ($80 to $180). (Global Financial Crisis) Recession 2008–1H2009.
- Feb 2016 – Sep 2018 – Oil prices rose steadily ($40 to $80). (Pandemic) Recession Spring 2020.
- Apr 2020 – Mar 2022 – Oil prices rose steadily then sharply ($20 to $110).
If this correlation continues, i.e. 11 out of the 12 spikes in oil correlated with a larger pullback in the markets, then we will see more down days ahead because it forces the Fed into a very difficult situation. Containing inflation and oil prices without triggering a larger market pullback will be close to impossible.
Furthermore, there are larger geopolitical events going on like the conflict in Ukraine and potentially Taiwan. So yes, there is a greater risk for a recession or a deeper correction.
So, given this backdrop, why do we not get out of the markets more significantly or all together?
Historically, timing the markets has been challenging because you have to get both the exit and entry correct in order to beat doing nothing. Investors with the most accurate and timely information get this wrong consistently. But risk managing in incremental terms has been proven to be effective and we have done exactly that. By positioning defensively since the end of December and in early January, we have been as conservative as you can be within the risk tolerance models. Even though we are signaling an 80%+ chance of further drawdowns, that does not provide 100% of the severity of a market crash, and therefore, we cannot make long-term decisions based on short -term noise of the markets. Volatility is just part of the price we pay for having investments.
I should also point out that I have heard of reducing risk tolerances as a logical step to reduce drawdowns, however, that should only happen when life changes or when you have reached a milestone. At that point, you are ready to de-risk, you are in control, and it is not your emotions reacting to events outside of your control. Keep in mind that some of the best days in the market are surrounded by extreme volatility.