January 03, 2023
Setting Expectations for the New Year
To access the Investment Strategy Notes, click the “Download” button on the right.
While we’re kicking off a new year, not much has changed on the economic front. The Fed is still tightening, the risk of recession remains elevated and stocks are still in a bear market. As it stands now, investors should remain defensively positioned in anticipation of further downside to the ongoing bear market. With that said, they should also be careful not to become too complacent with that positioning. In practice, investors should be constantly surveying the macroeconomic and market landscape for signs of an inflection point. The slide shown here is an exercise in the hypothetical scenarios that could prompt such a change in strategy. There are likely three main paths the economy and markets could take that could prompt a change in stance for investors. The first path assumes the U.S. avoids a recession, which likely means the Fed was able to wrestle inflation under control in a timely fashion without too much collateral damage in the broader economy to cause a downturn. The second is one where the Fed is not so successful at threading the needle and the economy does enter recession. And the third, which could very well occur concurrently with the second scenario, is a decline to fair valuation levels on equities. Let’s walk through these scenarios one by one.
For the first scenario, where the Fed achieves a soft landing and avoids recession, it’s so far so good. Quarterly real GDP growth, which ticked up positive in Q3, is expected to remain so in Q4. While there is an informal shorthand definition that two straight quarters of negative growth typically means recession, the official definition is a bit more involved than that. The National Bureau of Economic Research makes the official call on when the economy enters recession, though their academic approach tends to lead to significant lag times in calling such crucial turning points. Instead, investors should keep an eye on some of the variables the NBER tracks, such as employment, industrial production and retail sales. Of the three scenarios, this is probably the least likely to occur. But if it does, it likely means the Fed was able to bring inflation under control relatively quickly, keeping the U.S. economy in its late stages for the time being.
The biggest reason why avoiding a recession is unlikely at this point is that the Fed has taken rates into tight territory. Monetary policy notoriously flows through to the economy with long and variable lags, so the impact is unlikely to be felt immediately. What’s more is that the Fed plans to continue raising rates into 2023, which should start to have negative ramifications for the real economy and lead to recession.
Some of those variables that might give a clue as to when a recession is unfolding have remained healthy for the time being, but investors should be watching things like capital expenditures and the unemployment rate. Rather than waiting for the NBER to make their recession call, these variables could start to give hints of trouble on the horizon for the economy ahead of time.
If the economy does start to take a turn for the worse, such an event should impact corporate earnings and perhaps trigger further declines in equity prices. Looking at the history of earnings declines during recessions, this comes out to a 15% hit on average. A 15% decline would lead to about $190 earnings per share. That’s materially lower than the $230 mark that analysts are currently pricing in. This is another factor that could prompt further declines in stocks, as earnings weakness becomes a reality. This recession scenario is the base case at this point in time. Once the recession begins, investors should be looking to key leading indicators for green shoots that could herald a durable recovery in the economy and the start of a new economic cycle.
The third scenario is a decline to key valuation levels, where stocks begin to trade at such a discount that it no longer warrants an underweight position. During periods of economic stress, it’s common to see valuations dip below fair levels, but that’s something we have yet to see this time around.
In general, equity valuations tend to be sensitive to the stages of the business cycle, where they have historically traded at deep discounts in recessions, recovered coming out of recessions and peaked around late cycle. Glenmede’s Global Expected Returns Model suggests that the 3250 level on the S&P 500 marks fair value. Below that level, investors seeking buying opportunities should look to those turning points in the economic cycle and perhaps contrarian sentiment signals to appropriately time adding to risk.
To summarize, given the ongoing economic uncertainty, investors should maintain an underweight to risk assets, but should also be surveying the scene for the trigger points that could warrant adding back to risk. The first trigger, though unlikely at this point, is if the Fed achieves that soft landing and avoids recession. The more likely outcome is a recession in the U.S. that also hits corporate profits. Such a scenario suggests further downside for equities in the near-term. And the third scenario, which could happen concurrently with a recession, is a decline to more fair valuation levels. Given this outlook, investors should stay underweight until they begin to observe midrecession green shoots of recovery and/or more attractive valuations before getting more constructive on risk in their portfolios.