To Recession or Not To Recession - That is the Question
Where is the Recession?
This is the most anticipated recession in my 33 year career. Where is it? Maybe it is happening right now. It’s hard to know, because we don’t declare a recession until 2 or 3 quarters after they happen. The data looks backwards. We do get forward indications, but things can turn around. And in 2023 we have clear evidence of a slow down everywhere except the consumer. So the answer will likely be the consumer’s willingness to continue to increase their dependence on credit to keep up with the inflation that has been wreaking havoc on the country and the developed world for the last 2 years.
So much of the recent conversation centers around a soft landing, where we slow down just enough to take the inflationary pressure off but not cause a recession.
In the past 30 years the Fed has been prone to over stimulate (take rates too low for too long) and over tighten (take rates too high or raise them too quickly) only to do it all over again. This has tended to create a boom and bust scenario.
So, here we are finding ourselves wondering once again, has the Fed broken something and folks are looking around for the next “Black Swan”. It is our opinion that instead of looking for something you will never see coming, we should take advantage of what the market presents to us to increase the protection in our portfolios while strategically positioning us for increases in equity prices that increased earnings will ultimately bring about.
Most Attractive Bond Market in 15 years
The big rate increases in short-term interest rates that have inflicted excess turbulence of bond markets in the last 2 years presents an opportunity to investors who extend duration (average length of time it takes to get your money back from the cash flow from your bonds).
We did some of that late last year and we will likely add more in the first half of 2024. This will provide better protection against equity market declines than at any time in the last 15 years during the near zero interest rate environment. It will also provide the highest income payments since before the credit
crisis of 2007-2008. A win-win for investors.
Regional Banks Will Remain Under Stress
The banking sector must adjust to the new interest rate regime. That requires careful management of assets vs liabilities to meet appropriate liquidity for the bank’s depositors and creditors. As we saw early last year there will be banks that make mistakes. We think the regional banks will continue to be under pressure in the foreseeable future and some will fail. The Fed has a clear eye on this and hopefully is examining banks to keep this to a manageable level. We are not worried about a systemic problem in the banking system.
Regional banks have a high exposure to commercial real estate and many of these loans will go bad as leases expire and tenants shrink their footprint in the new remote working America. These banks may have to take big losses on these reserves.
If the rates stay higher for longer, then eventually the bigger banks will be forced to pay up for deposits as they compete with money markets and short-term government debt for cash reserves.
Consumer Debt Approaches Pre-Pandemic Levels but Now at Higher Rates of Debt Service
The consumer has been using new debt to keep up with inflation and to experience all the things they missed during the pandemic (travel, concerts, restaurant i.e. experiences). Delinquencies are rising to the highest levels since just after the GFC (Great Financial Crisis). Student loans have only recently begun repayments after a 3-year moratorium during Covid.
With rates higher for credit now, we think those delinquencies will continue to climb in 2024. We are of the opinion the consumer will soon pull back. Usually this is what pushes the economy into recession.
Value is Much More Reasonable Valuation Compared to Growth
Growth was the big winner in 2023 especially in the large cap category. Growth is nearly as overpriced as it was before the selloff in 2022. We are of the opinion that value presents a much more attractive risk reward going forward and we will strategically increase our value weights in 2024. As 2022 showed us when the market goes into a risk-off mind set growth can sell off dramatically and quickly.
We already pulled back in 2023 on growth relative to value, but we might look at this again if growth extends it overperformance relative to value in 2024.
Earnings Are Expected to Be Strong
Why are we optimistic that stocks could very well have another good year in 2024? Earnings, earnings, earnings. Ultimately, stocks follow earnings. Earnings turned decidedly negative in 2022 and stocks sold off as a result. Things were not as bad as expected and that explains the snap back in 2023. If analysts’ projections are close, the market should see higher prices. The estimates are subject to change and so we will pay close attention to the changing estimates in 2024.
I often get asked about the elections and their impact on portfolio returns. I know that the political climate is as bad as it gets and only seems to be getting worse, so I understand the concern. But we have had very contentious elections before when at the time I am sure they felt the same way, that it couldn’t get worse. The markets still went on to perform the same regardless of who won, Democrat or Republican. We recommend not letting politics guide your investment approach.
We will likely have more to say on this topic as the year moves forward.
The National Debt Remains A Concern
The national debt is a long-term problem and will require very difficult decisions, but it will not affect markets in the short run as the problem can and will be resolved. Markets don’t have a way of factoring that in real time. This is a political problem. Until investors know the solution it is difficult to factor the impact. What is clear is eventually the debt service will crowd out other spending and send taxes higher.
Why do I bring it up? Because I do not want it to be a surprise. This will impact assumptions about entitlements like Social Security, Medicare, and Medicaid. We have always factored in reduced expectations in our financial plans for clients under 50.
The debt payments are now nearly $750 billion. $7.6 trillion of the $34 trillion of national debt is going to need to be refinanced in the next 12 months. Rates are substantially higher than they were in the middle of Covid when $6 trillion was spent to get us through the pandemic. Rates at that time on 2-year us government debt was less than 1% today it is north of 5%.
Debt payments as of the 4th quarter of last year were $739 billion. By the end of next this year the payments will exceed $1 trillion and be larger then either the Defense or Non-defense spending.
Compared to March 2022 when inflation began debt payments were $306 billion.
In summary we are cautiously optimistic despite all the geopolitical risks and US political disfunction that the economy remains strong. Earnings should take center stage in 2024. Big banks are very well capitalized, and corporations have a lot of cash on hand. With the additional income from our bond positions portfolios should have a little less volatility compared to any period in the last decade. There is always the possibility of something that surprises, but isn’t there always something we didn’t expect.
Bryan D. Beatty, CFP® AIF®
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.