by Erik Ristuben, Russell Investments
Inflation has skyrocketed to 40-year highs. The U.S. Federal Reserve (the Fed) is in full-on tightening mode, with markets signaling as many as 11 rate hikes this year. U.S. government bond yields are up almost 150 basis points since 2022 began.1 And media outlets are starting to sound the alarm on potential recession risks for next year.
Amid this backdrop of increasing pessimism, investors may be tempted to respond by doing something in their portfolios—whether it’s dialing back on equities or increasing an allocation to fixed income. But we believe that making changes like these today would not be in their best interests. Instead, we contend that investors are better-served by standing pat and sticking to their strategic asset allocation and portfolio weightings for the time being.
Why? Simply put, at this stage of the game, there’s not enough information about what could happen to economies and markets down the line to be placing any sure-fire bets. Yes, there could be a recession in 2023, but the Fed could also engineer a so-called soft landing, where it slows growth enough to tame inflation without triggering an economic downturn. Or, the U.S. economy could still slip into a recession—but not until 2024. It goes without saying that each of these scenarios would likely have wildly different implications for both equities and fixed income—and betting heavily on any particular one could prove to be perilous when so much is still unknown.
But why is there so much uncertainty about what lies ahead for the U.S. economy? The root cause of it all likely stems from the Fed’s recent shift to branding inflation as public enemy number one. Let’s take a closer look.
The Fed will fight inflation at all costs, even if a recession ensues
With pricing pressures continuing to broaden as the clock ran down on 2021, the Fed acknowledged late last year that inflation could no longer be described as transitory. The U.S. central bank quickly pivoted to a hawkish stance, announcing an accelerating wind-down of its quantitative easing program in December and signaling that multiple rate raises were in store for 2022.
The rate-hiking cycle kicked off in earnest in March, the same month that U.S. consumer prices increased at their fastest pace since December 1981. Since then, with report after report continuing to show inflation running at its highest levels in decades, the Fed has become increasingly vocal about its plans to aggressively bring pricing pressures under control, with Chairman Jerome Powell characterizing the fight against inflation as “absolutely essential.”2 Today, the proverbial rubber met the road, with the Fed instituting a 50-basis-point rate hike—the largest increase in the cash rate since May 2000.3 With the hike already priced in by markets, reaction in the wake of the announcement was initially relatively muted, with the S&P 500 Index climbing 0.4% and the yield on the benchmark U.S. 10-year Treasury note rising slightly. However, subsequent comments from Powell that a 75-basis-point rate-hike for June was not actively being considered sent equities roaring higher, with the Dow Jones Industrial Average closing over 900 points higher on May 4.
In our view, it’s highly likely that the central bank will lift borrowing costs by another 0.5% at next month's meeting, taking the federal funds rate to 1.25%. If we’re correct, this means that by mid-June, the Fed will already be more than halfway to what we believe is the neutral, or equilibrium, rate of 2.25%.
This is when we expect chatter over recession risks to start ramping up more. To be clear, such talk isn’t unusual, as the market’s primary concern in rate-hiking cycles is usually that the Fed will over-tighten monetary policy, raising rates to the point where the U.S. economy tips into a recession. Normally, however, this worry is offset by the Fed having a more balanced view on what its ultimate objective is. In most cases, it’s to hike rates into the neutral zone—the sweet spot where monetary policy neither stimulates nor hinders economic growth. In other words, the Fed usually tries to avoid making policy changes that could touch off a recession.
This time around, however, the central bank’s view is anything but balanced. The Fed has made it very clear that it does not consider a recession to be the worst-case scenario for the U.S. economy. The worst-case scenario, in the Fed’s mind, is persistently high inflation, à la the 1970s—an outcome the central bank wants to avoid at nearly all costs. Essentially, this means that the Fed is willing to put the economy into a ditch in order to tame inflation. Put another way, the central bank’s primary goal today is to extinguish inflation, not prevent a recession.
2023 recession risks likely to rise this fall
A general rule-of-thumb is that it typically takes 12 months or less for changes in U.S. monetary policy to work their way through the system and have real, demonstrable impacts on the economy. Assuming this time around isn’t any different, this means the impacts of the initial 25-basis-point rate hike in March would begin to manifest in the late winter or early spring of 2023, with the effects of today’s 50-basis-point increase showing up a month or two later.
Historically, another telltale sign of a recession is the inversion of the U.S. Treasury yield curve—where shorter-dated bonds yield more than their longer-dated counterparts. Because bond prices fall as yields rise, an inverted yield curve means that investors are selling shorter-dated debt in favor of longer-dated debt, reflecting waning confidence about short-term growth prospects. In many—but not all—cases, a U.S. recession occurs around 15 months after the yield curve first inverts. This lends some credence to the idea of a recession potentially beginning in the fall of 2023, given that the yield curve briefly inverted in March, when 10-year yields fell below two-year yields. While this segment of the curve has since un-inverted, the spread between the two remains quite narrow, at 16 basis points.4
A recession may be coming. But we think it’s still too early to de-risk.
This leads to the question of the day for many investors: If there could be a recession next fall, shouldn’t I start preparing by making changes to my strategic asset allocation or portfolio weightings?
To reiterate our point from the beginning of this post: No. Recession forecasting is not that clear cut. Uncertainty is high and it might still be too early to get overly defensive. Equities typically sell off about six months in advance of a recession’s onset5, which suggests that stocks may not begin to truly tumble until next March IF a recession does begin in the fall of 2023. In other words, de-risking now could mean forgoing nearly a year’s worth of reasonable equity returns. Case-in-point: The average return for equities in the year leading up to a recession is 6%.6 And what if the recession doesn’t set in until 2024? What types of gains could be missed out on then?
Let’s broaden this argument out a bit by looking at how equities have historically performed during times of rising rates. The chart below shows the total returns during previous Fed tightening cycles dating to 1976, broken down by stocks, bonds and a typical 60/40 stock-bond portfolio.
Click image to enlarge
Source: Morningstar, St. Louis Federal Reserve and Federal Reserve Bank of New York. Stocks: S&P 500 Index; Bonds: Bloomberg U.S. Aggregate Bond Index; End of tightening cycle identified by Federal Reserve prior to 1990 and based on date of last Fed rate increase after. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. Returns based on monthly data.
As the chart shows, the average total return for equities over the past eight rate-hiking cycles was 17.4%, with 5.5% for bonds and 13.1% for a 60/40 portfolio. And while there certainly was some volatility (as shown by the maximum-decline-percentage column), most cycles yielded positive returns for both asset classes. Perhaps even more significantly, we’d add that the average return on the S&P 500 (not shown on the chart) during the first year of a rate-hiking cycle is roughly 7%.7
In addition, our composite contrarian indicator recently signaled that investor sentiment has shifted to a panic stage for the first time since the early days of COVID-19. From our vantage point, this strengthens the case for staying invested, as there could be some opportunities to buy the dip over the next several weeks.
Why today is also not the time to dump bonds
By the same token, just as we don’t believe investors should be selling equities, we also don’t think now is an appropriate time to be dumping bonds. Why? Because as recession risks rise, bonds are the natural offset to equities. In fact, they generally perform well during bear markets, for the simple reason that the Fed usually responds to recessions by lowering rates, causing bond prices to rise.
Look, we know bonds have been absolutely hammered this year. But if the U.S. is going to be staring down the barrel of a recession in 2023, the whole conversation about whether or not to own bonds will quickly become moot, with investors likely flocking to bonds in droves—and the real debate shifting to owning equities instead.
The bottom line
At the end of the day, so much of investing boils down to risk assessment. Earlier in the economic cycle, we thought that the balance of risks were skewed favorably for equities and other risk assets to outperform bonds. Today, we see the risks as being more balanced. Yes, there’s a risk to owning equities, but it’s offset by the potential upside of market gains over the next year. And yes, there’s a risk to owning bonds, but that’s offset by the diversifying role they’re likely to play when the next recession strikes. Ultimately, this is why we believe that remaining at your strategic asset allocation or portfolio weighting makes the most sense right now.
We understand that amid all of today’s uncertainty, the temptation for investors to do something in their portfolios is hard to resist. It’s only human, after all. But the bottom line is we don’t think it’s prudent to be making changes to an overall investment strategy right now. In our opinion, the best thing for investors to do today is to stick to their strategic asset allocation.
In other words, better to stay the course than to course-correct.
¹ Source: U.S. 10-year Treasury yield from Jan. 1, 2022 to May 4, 2022
² Source: https://www.cnbc.com/2022/04/21/powell-says-taming-inflation-absolutely-essential-and-50-basis-point-hike-on-the-table-for-may.html
³ Source: https://www.barrons.com/articles/federal-reserve-interest-rate-hikes-51648233547
⁴ As of May 4, 2022
⁵ Source: Russell Investments, Refinitiv, NBER
⁶ Source: Russell Investments, S&P 500
⁷ Source: Russell Investments, S&P 500
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