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Written by: Scott Colyer | Advisor Asset Management
There’s a lot of debate about whether the U.S. will enter a recession in 2023 or if the Fed can engineer a “soft” landing. We think those are a very mislabeled set of possibilities. It is our belief that there is never a soft landing when it comes to a Fed-induced slowdown in the markets. Asset prices almost always get punished when the Federal Reserve (Fed) tightens. At best it will only hurt a little, but at worst it will hurt a lot; no matter what, nothing about it will be soft.
It is our CIO’s belief that 2023 will likely bring a recession to the U.S. economy. We believe this because of the steep inversion in the yield curve and real threat from inflation. It is the likely persistence of inflation coupled with the Fed’s lack of effective tools to vanquish it that has piqued our interest. The Fed’s record-setting jumbo interest rate hikes this year are intended to destroy demand for goods and services, thus removing upward price pressures from the market. The Fed hiked interest rates by 50 bps (basis points) last week and we expect them to possibly raise rates by another 50 bps in February 2023. If that happens, the Fed Funds rate will be 5% which, according to our model, is just neutral.
History shows us very clearly that the Fed will have to raise rates ABOVE the rate of inflation and hold them there for an extended period.
If you take the Fed’s favorite measure of inflation, the core Personal Consumption Expenditure Index (PCE), which is currently around 5%, indicates that rates would need to be higher than 5% and stay there for an extended period to combat inflation.
The real risk may be the Fed’s balance sheet which has bloated to over $8 trillion. The Fed’s intent to sell these securities into a market that is losing liquidity has never been done before; we call it “quantitative tightening.” The world’s biggest buyers have become the biggest sellers. Global central banks are beginning to sell down their balance sheets after driving bond prices so high over the past 14 years that interest rates became negative in many parts of the world. Raising interest rates and simultaneously unloading trillions of dollars of bonds has numerous problems and risks. Remember, as rates rise the strain on the U.S. budget will grow larger, as the cost of debt will quickly rise with interest rates. The asset bubble is in the bond market and Fed Chairman Powell is trying to let the air out slowly.
What could go wrong? Interest rate increases are to an economy as administering poison is to a living being. A little might only make one nauseous; a little more could make a person stay close to the restroom; a lot will likely put someone in the hospital; and even more could put you in the cemetery. The poison works on the patient slowly, and the more resilient the patient is to the treatment, the more the Fed will likely administer. Then the Fed must wait to see how sick the patient becomes. The Fed has injected a large amount of economic poison into a very healthy U.S. economy, yet we have not seen the patient become very ill at all. Make no mistake about it, the Fed is trying to turn down the speed of the U.S. economy. They know this will mean higher unemployment, lower leverage, housing losses and increasing credit defaults. One thing is for certain, the Fed has an unlimited supply of poison in the form of interest rate increases, and they have used a record amount in a very short period. They are just guessing as to the dosage.
History shows that “soft landings” are anything but soft. Recall 1993–1994 when a so-called “soft” landing was achieved. The Fed very aggressively raised rates by 300 bps in a single year. What happened? Orange County, California was the first default with over a billion dollars in losses due to derivative exposure. Countries including Thailand, Mexico (which the U.S. bailed out) and Russia all defaulted. Both equity markets and fixed income markets were very volatile, which is difficult for investors. The Fed’s actions led to the Long-Term Capital Management L.P. (a highly leveraged hedge fund) debacle where a group of large investment banks split up the losses as a bailout.
There is nothing “soft” about people losing their jobs and their houses. Yes, the consumer is healthy now, but personal revolving credit has set new highs and savings rates have dropped. The government largess of direct transfers of money to the population has largely been squandered on speculation and folly. But that is how it typically happens. The problem is that after the crypto winter, meme stock follies and NFT (non-fungible token) mania, the U.S. taxpayer is left with the bill. There’s nothing “soft” about that.
As we enter 2023, we remain cautious about holding risk. With the U.S. economy likely rolling over, we like industries that often benefit from a weakening U.S. dollar. We like international markets where valuations are much lower than in the U.S. We believe strongly that being invested and staying invested are very important as market timing ultimately fails. We stress high-quality companies that earn lots of free cash flow and pay BIG and GROWING dividends. We like recession-resistant industries like healthcare, consumer staples, energy, some commodities, and emerging markets (including China). For income investors we continue to cautiously add duration but only in top-rated corporate debt. Economic slowdowns typically punish lower-grade debt. Those market have not yet begun to show the effect of the Fed’s poison. Don’t make the mistake of rushing in too soon on a Fed pivot call. As we move through the downcycle, the yield curve inversions will flatten and eventually turn positive. Finally, remember to dollar cost average. There is no hurry here. We think the first half of 2023 will be somewhat tumultuous, but the second half has real promise.