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Wealth Insights | Weekly Market Analysis | Economy | Asset Allocation | Fixed Income

Weekly Market Analysis: Observations & Recommendations for a Rolling Recession

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3 Things to Know

A different type of recession

Often economic history repeats itself. Not this time. The two most recent recessions were unambiguous. For investors in 2023, the economic outlook and market actions appear disconnected. This suggests we’re in a different type of recession, one that has elements that are contradictory in direction, but still material in size and scope.

The employment head-fake

The US economy has been experiencing both expansion and contraction in various industries at the same time. But CIO thinks the unusually long time it’s taking labor markets to be impacted by Fed rate hikes may be misleading investors – and Fed officials – into thinking there’s no slowdown coming. US employment dropped by a record amount in 2020 and the economy recovered rapidly that year, but many employers could not find basic labor. Many firms in 2023 are still hoarding labor as a result. Over the past year, demand ebbed and worker output fell 1%, yet total hours worked rose 2.3% over the same period.

When the US Treasury borrows again

Markets have priced out the chance of an emergency Fed rate cut in the near term. If a debt ceiling agreement and overconfidence on employment leads to a resumption of Fed tightening, it may raise the probability of a broader recession rather than the rolling recession now underway.

Summary

For investors in 2023, the economic outlook and market actions appear disconnected. It appears we’re in a Rolling Recession, one where we see contraction and growth in different part of the economy at the same time. CIO thinks the unusually long time it’s taking labor markets to be impacted by Fed rate hikes may be misleading investors – and Fed officials – into thinking there is no labor market slowdown coming. CIO still believes the Fed’s aggressive fight against inflation and the current delay in labor market weakness will ultimately cause the Fed to reverse course toward the end of 2023. This suggests the currently high overnight money fund rates and high yields of short-term T-Bills will not be available a year from now.

Portfolio considerations

Extending the duration of fixed income portfolios should be seriously considered after the debt ceiling issue is resolved. A backup in US bond yields and a temporary jump in the dollar could make for a potentially strong opportunity to add emerging market debt to portfolios.

Restrictive Fed policy means competitive yields, particularly at the front end

Source: Haver Analytics as of May 25, 2023. Past performance is no guarantee of future results. Real results will vary.

A different type of recession

In 2023, the industries that signal recessions are contracting and new sources of restraint are building. Tighter bank lending standards will lead to a deeper slump in commercial real estate investment. For the same reason, entrepreneurs will find it significantly more difficult to finance start up enterprises that are not quickly profitable. Layoff announcements in the IT sector have already surged. These are normal elements of typical recessions. Then, there are unusual economic events. Consumer services spending is growing solidly (though less rapidly) in recent months, whereas residential construction spending has collapsed 19% over the year through 1Q 2023. The travel and leisure industries can’t get enough employees while technology related businesses are seeing layoffs. Major stock indices have risen, but most stocks are flat to down on the year. This is atypical. It appears that contracting industries are beginning to make progress in reducing inventories. As inventories fall early in a recessionary cycle, it provides fuel for an eventual recovery. The situation is indicative of a rolling recession for the US economy. CIO sees these rolling recessionary elements occurring across the world economy, too.

The employment head-fake

US employment dropped by a record amount in 2020 and the economy recovered rapidly that year, but many employers could not find basic labor. Many firms in 2023 are still hoarding labor as a result. You can see this in the data. Over the past year, demand ebbed and worker output fell 1%, yet total hours worked by new and existing employees rose 2.3% over the same period. This has resulted in falling productivity and weaker corporate profits. On the other hand, this has sustained real personal income and spending gains, more so as inflation has fallen. This, in turn, will help cyclical industries work off inventories, mitigating their future impact once services spending slows. The absence of a major downturn in employment and the offsetting economic impacts of the Rolling Recession might result in another, more dangerous round of tightening financial conditions. This is when the current threat of US default ends with an agreement to raise or suspend the debt ceiling, enabling the US Treasury to borrow again.

When the US Treasury borrows again

What happens after any debt ceiling agreement is reached? Unlike 2011, when US equity markets fell by 15% after a debt ceiling agreement was reached, the present bearish positioning of investors suggests markets will likely see at least a short relief rally when a deal is struck. There’s more cash on the sidelines, in bank deposits, Treasury bills and money market funds than ever before. Shortly after an agreement, the Treasury will issue an enormous amount of T-bills to replenish its cash balance. Within a month, the supply of 1-12 month bills should swell by at least $300 billion in addition to normal redemption/issuance. Overall, net US Treasury borrowing by the end of 3Q 2023 is likely to be about $1.3 trillion. This has the potential to generate outflows from other asset classes – including bank deposits --given that these bills will, on average, yield north of 5%. This could put pressure on weaker banks as their deposit rates can’t easily compete with Treasury yields and money funds. We might see additional bank stress as a result, especially among smaller banks with large exposures to commercial real estate or those with high levels of uninsured deposits. Markets have priced out the chance of an emergency Fed rate cut in the near term. If a debt ceiling agreement and overconfidence on employment leads to a resumption of Fed tightening – even the mere discounting of it – it may raise the probability of a broader recession rather than the rolling recession now underway.

Portfolio considerations

Extending the duration of fixed income portfolios should be seriously considered after the debt ceiling issue is resolved. Rates are likely to rise for a short time just after the negotiations end. If that occurs, it will an ideal time to move from cash and cash equivalents to bonds that can maintain today’s high yields for longer. The resumption of Fed tightening, or markets’ anticipation of it, will likely cause the US dollar to jump. Yet ultimately, the Fed won’t be able to sustain a restrictive monetary policy as labor markets weaken, in CIO’s view. A backup in US bond yields and a temporary jump in the dollar could make for a strong opportunity to add emerging market (EM) debt to portfolios. After a substantial yield rise – and perhaps more to come after a US debt ceiling agreement – the case for adding to EM debt (USD-denominated) is building. For a smaller portion of an overall fixed income allocation, local currency bonds either directly (where available) or through global local currency index funds are an asset class that might attract attention.

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