Midyear Economic & Investment Outlook: Is A Recession on the Horizon?

By: Brian Seay, CFA

Inflation is falling, unemployment is rising and after a strong start to the year, economic data has turned noticeably weaker. Is a recession on the horizon? In our outlook we will talk about inflation, the jobs market and the economy. More importantly, we will dive into what the current economic outlooks means for investors in stocks, bonds, real estate and other asset classes. So if you are wondering if a recession is coming, and how to invest now, this is for you. Watch the video, or read the transcript below!

Transcript:

First, I always start with long-term returns. We will talk about what’s happened year to date and our outlook for the economy, but all of that is short-term in nature. Most of our clients, and most investors in general, have long-term goals. What the chart shows is that the most important fact in investing is choosing the right assets and sticking with it long-term. You can see over the last 28 years, the S&P 500 is averaging almost 9.8% per year in returns. Gold is just over 6.5% and Bonds just over 4.5%, all outpacing inflation, even after the recent run-up in inflation, at 2.5%.

When we zoom in and look at the past decade, The S&P 500 has returned just under 13% each year on average, followed by Global stocks at 9%, Gold and Real Estate near 6% and Commodities like oil and copper have produced negative returns over the decade.

When you think about the 28 year and 10 year history, you would be a very happy investor today if you invested at the peak of markets before the global financial crisis or right before Covid. Neither would have felt very good in the short-term, but returns since have been significant. Its so important to keep in mind your long-term goals and not get lost in the drumbeat of what can, and sometimes does, go wrong in the short-term.

Let’s talk about what has happened so far this year in markets.  Thus far the S&P 500 is leading the way with returns over 15.5%. Gold has done surprising well with returns over 12%. Commodities up almost 6%. Inflation is cooling off, the headline number for CPI is 3.3%. Bonds are essentially flat on the year and public real estate has had negative returns.

What’s been driving returns? Let’s start by looking at the economy and then we can dive into specific asset classes.

Coming into the year, our outlook was titled “The Sugar High is Over” and our basic thesis was that that higher interest rates would cause the economy to slow down and inflation to fall. That has largely been true. After a few years of above average growth, economic activity has slowed down. Real GDP is back to 2.9%. on a YoY basis and sequentially only 1.3%. That feels low compared to recent history, but it is very consistent with the growth we saw in the last decade prior to Covid. So economic growth is not negative, but it is continuing to make progress at slower speeds. The big reason for that is higher interest rates. Fed rate hikes from the last couple of years have made it more difficult to borrow to expand businesses and for consumers to keep spending.

That slow down, while not in the news has impact companies and markets. When we look at stock returns, most of the S&P 500s return for the year has come from the so called “Magnificent 7” growth stocks. Those include Nvidia, Apple, Microsoft and Google among others. In fact, the average” large cap U.S. company has seen their stock price increase only 5% so far this year. In fact, since the Fed started raising rates in 2022, the “average” S&P 500 company has increased in value just 1.7% IN TOTAL over the last 2.5 years.

Housing starts, which is the statistic tracking new home builds, have fallen since rates increased, meaning less construction activity buying any number of materials necessary to build homes. Lastly, retail sales have stalled out. You see long-term retail sales growing north of 4%, even more for non-store services. Both metrics are essentially flat year-to-date.

Let’s look at the jobs market. How is the slowdown impacting employment? The jobs market has come back into balance. We have been looking at this chart for the last few years and assessing the gap between job openings and those looking for work. There are still more jobs than available works, but that gap has closed significantly. We had a small gap between openings and unemployed workers before Covid, which was pushing up wages slightly. We see a similar gap today.

Demand for workers is still ok, and unemployment remains low on a historical basis. You will see all kinds of news about unemployment rates ticking above 4%. However, unemployment at 4.1% or 4.2% is still historically low. For a recession, we need to see unemployment move materially higher. Immigration and additions to the labor for are not enough to move the needle. For unemployment to move materially higher, layoffs need to increase materially. In the next chart, you can see layoffs across the economy. If anything, layoffs remain low compared to historical levels, despite what you hear in the news. 1.5MM layoffs every month is just the normal churn in the economy.

So raising rates has slowed down growth, and it is impacting the economy outside the high-growth sector.

The result of all the slowness and labor market rebalancing is that inflation has fallen considerably and will likely continue to come down. You can see the red line is the high Fed Funds rate, and when that is above the inflation rate, which the CPI is the green line and PCE is the blue line, the Fed is enacting restrictive monetary policy that puts the breaks on. In prior forecasts we discussed shelter extensively so I won’t do a deep dive here, but shelter, specifically owners equivalent rent is a significant part of the inflation metrics. That makes sense because it is a significant part of most household budgets each month. It shouldn’t be ignored. However, the methodologies used to track shelter inflation mean that it is incorporated into the inflation stats with a lag. If we used more current rent or shelter stats, we would be at the 2% inflation target today. So continuing to wait for inflation to fall based on lagged shelter stats may cause the Fed to overshoot and create a recession. It’s also important to note the difference between the Core PCE (Personal Consumption Expenditure Deflator) and Core CPI (Consumer Price Index). The Core CPI is reported in the news most frequently, but the Core PCE is likely a better indicator of underlying inflation and is used by the Fed. The CPI is typically above the PCE by one-third to one-half of one percent, even more so now. So if the headline CPI is just below 3%, then PCE should be pretty close to the Feds target. So we are getting close to target, especially when we apply the right analysis of housing to the inflation stats.

On the chart, you can see the Fed Funds rate typically sits right around the Core CPI number, perhaps three quarters of a percent above the PCE inflation number. That’s neutral and allows the economy to grow on its own. Right now the Fed Funds rate is 2% above the core CPI number, which is creating a lot of downward pressure on the economy.

I think the big risk currently is that the Fed overshoots its target. Corporate growth is slowing, consumer spending is flattening out and inflation is very close to being back on target. When the Fed cuts rates, they usually do so by a quarter of one percent at a time. Since they are 2% or more above neutral, that means that have many cuts to make before they get back to a neutral stance, even if you believe, like me, that neutral is higher than it was prior to Covid. Even if the Fed only does 4 rate cuts over the next 12 months, they will still be apply fairly strong downward pressure to an economy that is flattening out, which may push us into a recession. I’ve been a card carrying member of the higher for longer club for several years – but now I do think it’s important that Fed begin normalizing rates – just as the economy has normalized. I expect they will cut rates modestly in the last quarter of the year.

By the way, some wonder why the target is 2% and not 0% or why the Fed doesn’t want to cause prices to decline given all of the recent inflation. Outright deflation creates its own set of problems. First, if you think prices might go down in 6 months, you are more likely to delay purchases, which creates a downward spiral for consumer and business spending. Second, developed economies have lots of debt. If the assets underlying that debt depreciate, you see people walk away from loans and lots of other bad things. That’s what we saw just a little of in 2007 and 2008, so we don’t want to repeat that. So slow and low price growth is the way to go.

So what does that economic backdrop mean for investors?

First, lets look at stocks. Analysts are expecting S&P 500 earning to increase to about $245 this year, up 11% over last year. I see that as reasonable. However, for the market to keep moving up from here, earnings need to grow 18% over the next 12 months to $260/share. That seems to be a big increase in the current environment.

Here are a few examples of what companies see happening in the real world. I always listen to earnings calls to get a cross section of real business views from the economy.

Walmart is doing well. In Q1, they were unsure about the outlook. Now, they are clearly the beneficiary of consumers looking for cheaper goods. Target, meanwhile, is struggling as they see discretionary spend dropping and consumers trying to stretch their budgets. They are cutting prices this summer.

Caterpillar, the construction equipment company, has a healthy backlog and see sales to be similar to their 2023 levels. Not up much, but not down much. They say construction activity is healthy, but not increasing. Honeywell see sales growth of 4-6%

Drugmaker Eli Lilly expects strong growth this year, closer to 30% of its business. Business consultant Accenture is “performing well in a challenging macro and sees companies reducing their discretionary spending.”

J.P. Morgan highlighted muted demand for business loans, no doubt due to higher rates.

So will earnings grow this year, I think so. Will they grow 20%? That seems unlikely. Sometime more in-line with 10-12% historical growth seems more achievable if the consumer and employment situation hangs in there.

You can see that over time the market should broadly track earnings, after-all, the profit of the company is what you get as a shareholder when you buy a stock. I showed the year-to-date chart earlier, but the S&P as an index is up over 15% year-to-date. So some of that gain is likely warranted, the rest of the exuberance around AI and the future prospects of the 7 growth stocks that have been driving the market. The price multiple for stocks is 21x times the next 12 months earnings, which is above average but not the 23 times we saw a couple of years ago. Historical data shows that valuation is a good indicator of future long-term investment returns, but not a good tool for short-term market timing. The market can stay over or under-valued for long periods of time. I think staying diversified here makes sense. In order for the market to simply maintain its current levels, companies, especially the AI contingent, need to do extraordinarily well in a challenging environment. I think the odds are more likely that they don’t quite live up to the hype short-term than they are that we see another year of 20+% gains on the S&P 500. That doesn’t mean we are about to fall off a cliff, but if we simply closed the year here at up 15% for the year, any investor would take that as a great year.

When we look at global stock markets, the US continues to lead the way. Europe is not in a recession, but growth is very anemic. In a lot of ways, similar to the U.S., the largest growth companies ASML (semi-equipment) and LVMH (luxury) are doing well, keeping pace with the S&P, while the rest of the market is falling behind. Japan, Korea and Australia are going through similar low growth periods. Select emerging markets, especially India and Brazil are doing well. Our view continues to be that picking the right high-growth companies in international markets is a better strategy than trying to choose countries or benchmarks that will outpace U.S. growth.

Lastly, because S&P 500 stock returns have been so significant over the past decade, clients ask questions like “why invest anywhere else besides the U.S.?” or “if the U.S. continues to be the greatest economy in the world, why invest in other assets?” It’s really easy to look at the least decade and conclude that recent history will repeat itself. However, investors did not have the same perspective, or ask the same questions in the 1980s, early, 1990s or 2000s. You can see in the chart, the S&P 500 was the best performing asset class by far in the tech bubble in the 1990s and then during the 2010s. However, in the 1980s, International stocks far outpaced the U.S. during the rise of Japan’s economy. International stocks beat the U.S. 3 to 1. In the 2000’s the tech bubble collapse and financial crisis meant that Gold and Emerging Economy stocks were the best place to be by far. In fact, after strong periods of outperformance, top performers tend to struggle for years. The reason is that markets are not the economy. The internet brought on by the 1990s tech bubble created significant growth, far exceeding anyone’s expectations. But that growth was pulled forward into returns during the 1990s and, after the bubble burst, it took many companies a decade or more to return to their previous highs. Markets discount future activity, so after big price increases, they may need time for the actual growth in the economy to catch up. While that occurs, other assets outperform. When building portfolios designed to provide returns over 20 or 30 years, history shows that it is unlikely that any single asset class, including the S&P 500, will provide the best returns over the entire time-period. A well-diversified portfolio will not reach the highs of the best asset class during the best times, but it will also not reach the lows of the worst asset class over subsequent decades either.

Turning to Bonds,

As I mentioned, we see inflation and rates as moving lower. On the chart, you can see the yields, or the interest payments, coming in from various types of bonds. If you look at the brown line, you will see it moving up when Fed rate increases started and crossing over the pink and green lines. The brown line represents short-term, adjustable rate investment grade (so strong credit) debt. The yield curve is inverted because those short-term loans pay higher rates than intermediate and long-term investment grade debt. Given our view on declining rates, those short-term rates will start to trend down over the next year. As that happens, investors should be thinking about moving from cash to longer-term bonds. You can see on the next chart, year-to-date, short-term bonds and high-yield bonds have outperformed longer-term investment grade bonds. But on the right-hand side you see how quickly that can change. When rates begin to fall, like last fall, longer term bonds outperformed their shorter-term peers significantly. Our view is that continuing to own higher-yield bonds that pay high coupons makes sense as we don’t see an imminent recession, but investors should be moving from short to long-term bonds to take advantage of lower rates. Moving simply from short-term to medium-term costs you a lot in short-term yield while hoping for rates to come down. Adding to long-term bonds while maintaining exposure to high-yield bonds also minimizes the give-up in current yield.

In Real Estate, higher rates and increased vacancies in office space have driven prices down since their peak in 2022. You can see rates rising and REIT prices falling in the chart. Office properties will continued to be troubled for several more years as company leases roll over and they reduce space. Even with workers back in the office, few companies need as much space as they did pre-pandemic. Trophy properties will continue to do well, but there is a lot of so called class B and C office real estate that will suffer for a few more years. Outside of office, I do think buying “new” properties or funds is a sound strategy. As real estate starts changing hands a lower valuations that reflect higher rates, investors should be well positioned over the long-term. It’s important to be careful because many funds and REITS include both new investments and older properties that are still marked at higher prices. So I would be thoughtful about buying funds or properties that have been created in the past few months. National home prices are up 6% over the past year as single family residential real estate supply remains constrained.  Short-term rentals could also start to become attractive again, as rates come down the cash flow prospects of those properties will improve. I view single-family residential real estate and perhaps some commercial and industrial properties as perhaps the best real estate opportunities in the current environment.

Lastly on Gold, gold prices are up year-to-date. I view gold as an important inflation hedge, but also a diversifier against unexpected scenarios. I don’t expect stagflation, but gold is the best hedge if that were to occur. Gold will also do well in a recession if the economy rolls over more quickly than we anticipate. Foreign central banks are buying more gold to reduce their dependence on the U.S. dollar. The demise of the dollar’s primacy globally is way overstated – it will be the world’s reserve currency for many more years. But there is a slight rebalancing occurring away from the dollar and that benefits gold over the next few years.

What to do now?

Rebalance run away equity positions. We are overweight U.S. large cap growth and I think that continues to make sense, but its also important not to get carried away. If earnings come in light for one quarter, those stocks will move lower quickly so its important to rebalance as you benefit from their outsized growth.

Second, I think the risk environment is much more balanced than we have had over the past few years. We very well could move into a recession if rates are not reduced meaningfully over the next 12 months.  Key items to watch are retail sales, business capital investment and loan default rates. If those data points continue to get worse, then they point to a recession. That means investors should be buying long-term high quality bonds, not just equities in their portfolio.

I would also consider real estate, especially if you have the option to buy a single property that is potentially distressed or in need of new financing.