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Key takeaways:
- Potential for more than 2 quarters of negative GDP
- Consumers face headwinds ahead
- Fed continues its policy of rate hikes
An overview of the current environment:
As we update our model with month-end data from August, there is a 71% chance that we could be in a deflationary (quadrant 4) environment for the next 4 quarters (2022Q3- 2023Q2). For this scenario to happen, we would have to have at least 2 more negative GDP quarters ahead which would put us well down the track of a recession, and therefore, we believe from the data that we are very early in this bear market. Keep in mind the Fed has never done as much quantitative easing as it has done over the last several years and therefore no one has lived through as much quantitative tightening as we are starting to go through. Therefore, this bear market has the potential to remove as much wealth as the great financial crisis of ‘08 and we must factor that into our positioning without knowing what the future holds. The US dollar, gold, short government bonds, utilities, and consumer staples remain our key holdings.
Our investment process:
Fundamentally, our investment portfolios are built on BlackRock’s long-term asset allocation models coupled with our risk management framework. Our risk management process is built on growth, inflation, and policy decisions over the full investing cycle process. Tracking these variables allows us to position assets with the highest risk-adjusted returns for the current environment. Specifically, we are tracking the rate of change between GDP and CPI for our framework. Let’s dive into some of the data and take a deeper look at growth, inflation, and policy.
Looking at growth – As mentioned above, growth is clearly slowing. Businesses are struggling for many reasons, one of which is directly related to increased financial insecurity for most consumers. For the bulk of Americans, the cost of living has increased dramatically and for most households, 62% of all income is going to shelter, food, and energy cost. Even though average income has increased, real wages continue with a slightly negative trajectory relative to inflation. Simply put, when life becomes more expensive, real consumption capacity declines rather quickly. The last jobs report highlighted a new record high for multiple job holders trying to make ends meet. Other consumers are relying on credit to close the gap. Nationally, consumers have about 4-6 months of credit remaining and are facing increasing credit card payments as the Fed continues to raise rates. These statistics paint a very bleak picture for consumers ahead. For businesses, without consumers’ spending capacity, inventories are growing and more importantly, margin pressure is growing even faster. Profitability has become a greater problem and earnings data has just started to decline. Growth data continues to decline and therefore the probabilities of a recession are increasing.
Looking at inflation –Headline inflation continues to decelerate year-over-year. There are several components of inflation which we have detailed in previous posts. With today’s (9/13/2022) CPI print of 8.3%, year-over-year, core inflation still continues to be a problem. In this newsletter, I want to focus specifically on the largest component of core inflation: shelter. Shelter or housing makes up 1/3 of the CPI calculation via an aggregation of rent data. As such, we anticipate that the Fed will not be able to meet its long-term inflation goal because of growth in rent. The increase in the growth rate of rent alone is staying constant at 6% year-over-year. Therefore, inflation from housing alone will represent a minimum gross total of 2% of CPI (1/3(component of CPI) of 6%= 2%). Meaning all other factors in CPI would have to hit 0% increase to hit the Fed’s long-term objective which is unlikely. As a result, housing will drag CPI higher and inflation will continue to be a problem into 2023.
Remember in terms of rate of change, inflation will be decelerating but the absolute numbers will be high; for example, inflation moving from 5% to 4% is a sizeable percentage drop but the ending outcome at a 4% inflation rate is still a relatively high rate.
Looking at Policy – Thinking the Fed could get a soft-landing right is becoming increasingly unlikely much like when the Fed viewed inflation as being transitory. As the Fed continues to raise rates into a slowdown; we slow down faster. Currently, the market expectations are for rate hikes in both September and November. These rate hikes specifically would raise the probability of a prolonged deflationary environment. Even Powell reiterated his hawkish stance in a speech in Jackson Hole:
“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 unfortunate costs of reducing inflation. But failure to restore price stability would mean far greater pain.”
Next steps:
From a risk perspective, we are looking at how a deeper or prolonged recession would impact cash flows and liquidity. A ‘financial crisis’ type scenario has crossed my mind multiple times as we explore uncharted territories of quantitative tightening of this magnitude. In 2008, I was working with clients or glued to CNBC and market news. I witnessed a lot of pain and emotions. I had a lot of pain and emotions as well working with 200+ clients and having the same conversation. I worked from 6am to 6pm fueled by fast food and coffee. In 2010, I was working in New York City where I witnessed the flash crash and the BP oil spill in the Gulf. I don’t know what the next leg of this market journey will entail but odds are pointing to further unpleasantness ahead.
At the beginning of this year, we reduced equity exposure across the board by 10%. We have removed almost all high-risk investments and hold mainly quality large US companies (utilities, consumer staples and health care); within bonds, our largest position is in short-term treasuries; and we have sizeable positions in gold and USD. These are very defensive positions in a long-term portfolio relative to the market, but even with these defensive positions there will be more volatility and we are here to help you through this volatility. We are strong as a firm that experienced several market cycles and will be here to guide you through many life decisions you will be making in the face of this volatility. Questions typically entail uncertainties around cash flow, gifting, and impact on longevity of assets. If you are having these thoughts or questions relating to your investments, please reach out to us. We are here to help.
Related: Can Congress Reduce Inflation?