by Paul Eitelman, Russell Investments
Everything about the COVID-19 recession and its subsequent recovery has been extreme. The period from 2020-2022 holds distinction for:
- The sharpest economic downturn, ever1
- The shortest recession, ever2
- The fastest economic recovery, ever3
- And the largest positive surprise for corporate earnings in a calendar year, ever4
Over the last two years our portfolio strategies broadly benefitted from a focus on assets that perform well during the recovery phase of the business cycle—namely overweights to risky assets (e.g. stocks, corporate credit and real assets) and tilting towards\ investment styles that offered cheap exposure to cyclicality (e.g. value equities).
Has the U.S. moved from recovery phase to expansion phase?
However, business cycles always mature and this cycle, in particular, appears to be aging VERY fast. Significantly above trend GDP (gross domestic product) growth has fully exhausted spare capacity in the U.S. labor market. The unemployment rate has dropped below 4%. There are almost two job openings for every unemployed worker in America (another record). And wage inflation has skyrocketed above 6% as the competition for talent intensifies. These observations suggest we have already transitioned from the recovery phase to a more mature expansion (or boom) phase of the cycle. To reiterate the salient features of this regime:
Boom. Years of above-trend growth in the recovery phase gradually exhaust spare capacity to the point at which the economy starts overheating (e.g. excessive investment, excessive hiring, excessive leverage). Inflationary pressures start to rise. Equities and real assets generally do well. Government bonds may re-price and return less than their current yield. Given recessions are exceptionally difficult to forecast, having a convicted tactical asset allocation can become very challenging in this phase of the cycle as both upside and downside risks are significant.
That paragraph holds up surprisingly well 20 months later. It should come as no surprise that as our views have evolved, we have reduced the amount of risk we are spending on tactical decisions. Our portfolios and our advice to clients are now focused on maintaining discipline to the strategic asset allocation.
Dented, not derailed
Are recession risks for 2023 on the rise?
What’s next? Well, recession risks are (still) exceptionally difficult to forecast, but the risks of an economic downturn do appear to have increased notably for the second half of 2023 and beyond. The overheating labor market and the U.S. Federal Reserve’s rapid shift away from an accommodative monetary policy stance are key drivers of concern. The Treasury yield curve has flattened considerably on the back of these developments, with the important 10-year/2-year spread briefly inverting last week. 30-year fixed mortgage rates have spiked above 5% and appear to be acting as a speed brake on new demand.
Can the Fed avoid a hard landing?
The big, open question here is if the Fed can slow the economy without killing the cycle. Their track record in engineering a so-called soft landing is not comforting. The good news is that macroeconomic imbalances (outside of the labor market) do not look dangerous. Companies have not overinvested. Household debt levels are not alarming. And corporate debt service looks very manageable. Nevertheless, if the Fed does follow through with the hikes that are priced into fixed income markets and take the proverbial punch bowl away, recession risks will increase.
The bottom line
We have gradually transitioned our positioning from a risk-on posture earlier in the cycle to a more neutral setting today as downside risks intensify. This is not a clarion call to go to cash. Staying invested and staying disciplined to your strategic asset allocation as critical as ever in achieving and improving upon financial security.
1 The 37% annualized decline in US real GDP growth in the second quarter of 2020 was the largest ever since official quarterly data began in 1947. Coming in a not-so-close second place was a 10% decline in 1958:Q1.
2 The NBER business cycle dating committee scored the 2020 recession as only lasting for two months, making it the shortest peak-to-trough contraction in their records which span back to 1857.
3 The 11ppt decline in the US unemployment rate from April 2020 to March 2022 far exceeds any other labor market recovery in monthly data going back to 1948.
4 At the start of 2021, bottom-up equity analysts expected S&P 500 earnings growth of 21%. Realized earnings growth for the S&P 500 was almost 50% in 2021, marking the biggest positive surprise in consensus data which spans back to 1986.
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