You may remember that we titled last quarter’s market summary “On the Verge of a Recession.” Our Investment Committee continues to see a recession signal on our radar — and we may even be in a recession now. It takes two consecutive quarters of negative GDP growth to technically fall into recession territory, so we won’t know until end-of-month metrics come in.
The Atlanta Fed GDPNow, a widely followed forecasting model for GDP, already predicts Q2 to be negative (-1.9%, to be exact). The model considers several leading indicators to predict where the economy is headed. With negative growth in Q1 already realized, negative growth in Q2 would put the US economy into recession.
In the meantime, the big two topics on investors’ minds this quarter were monetary policy and market cycles. Let’s dive in!
Understanding Monetary Policy
To better understand what’s going on with monetary policy, let’s take a look behind the scenes at how the Fed influences markets.
The Fed has two primary methods of impacting markets:
1) raising or lowering rates at the window
2) talking about their forecasted policy in the future (“jawboning”).
The Fed releases its monetary policy updates — called the Summary of Economic Projects (SEP) — four times a year. We’ll look at their June release momentarily, but first, how does this work?
Each FOMC member forecasts a federal funds rate target range for the end of the year. Their projections are aggregated into a dot plot graph. Looking back to December 2021, they showed a forecast for 0.75-1% by the end of 2022 and a 1.5-1.75% target range by the end of 2023. We are halfway through the year, and the fed funds rate target range is already at 1.5-1.75% with expectations of an additional 75-100 basis points coming this month!
Why such a dramatic change from the previous forecast? Inflation did not turn out to be transitory. The latest CPI report at 9.1% ((all items) gives no sign of slowdown. When looking only y at the latest month, core came in at a shocking 0.7 (8.4% annualized). We tend to be pessimists, but this caught us by surprise.
Unlike 2021, where the market anticipated an accommodative fed, the 2022 forecasts (compare below to the previous image) predict a restrictive monetary policy path which the market is now anticipating a slow in the economy with inflation remaining above the longer-run neutral rate.
Simply: the market had to absorb a financial tightening cycle that was not originally forecasted entering this year.
The Market Is Forward Looking
This sounds overwhelming, but remember, the market is “forward-looking.” We see that the market is expecting the Fed to take rates to 3.5% this year, so that is what we need to focus on.
While recessions are certainly disconcerting, you don’t necessarily need to fear them. The financial cycle (stock market) goes up in anticipation of the business cycle (economy) being strong, and down in anticipation of the business cycle being weak. Or simply, the stock market leads the economy. This means the stock market may begin to rally while the economy is still deep in a recession.
We can review a few scenarios using this framework:
· No recession: The economy slows but does not fall into recession. Inflation drops back toward 2% and monetary policy does not become/remain restrictive. The future prospect of recession can be pushed out into the future, the business cycle rebounds and the market could have already put in the trough earlier in June.
· Current recession: The economy enters recession in 2022. Inflation remains sticky through the end of the year but starts to ease which allows the Fed to only remain restrictive for a couple of quarters. Most of the market decline would be priced in during the 1H, a trough could not be put in until a path out of recession emerges (likely Q4). Meaning most of the pain is over, but a sharp rally is still months away.
· Persistent Inflation: The Federal Reserve tries a balancing act by raising rates, but not to a sufficient pace to slow inflation. This could disrupt businesses that struggle to calculate where to deploy resources and labor causing a ‘stagflationary” environment where hiring slows but prices rise. Look at the 1970s as an example.
So What to Consider
Continue to pay close attention to the market while keeping in mind your financial goals. Inflation is and is likely to remain above the average bond yield. Look for more defensive positions to offset any growth names in your portfolio. If the third scenario becomes the base case (currently it is not), we would want to consider commodities and real estate since they have historically appreciated in a prolonged inflationary environment.
Our Commitment
As always, the GWS Investment Committee is committed to the following investment management goals for our clients in 2022:
1. To pursue long-term returns that first and foremost strive to help clients work toward all goals in their financial plans.
2. To seek excess return above each portfolio’s benchmark over a three-year trailing period and a full market cycle, to hopefully cover client fees and add surplus to their portfolios.
3. To implement investment strategies that align with each client’s volatility and benchmark sensitivity to help them remain confidently invested and long-term focused.
It’s our GWS vision to provide an unparalleled enduring level of care to families on their path of giving purpose to their wealth. Please do not hesitate to reach out to your lead advisor with any questions or concerns — we are here for you!
Important Disclosures
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. Investing involves risk including loss of principal.
Investments in real estate may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Other risks can include, but are not limited to, declines in the value of real estate, potential illiquidity, and risks related to general and economic conditions, stage of development, and defaults by borrower. The fast price swings in commodities will result in significant volatility in an investor’s holdings. Commodities include increased risks, such as political, economic, and currency instability, and may not be suitable for all investors.
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