By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
February 1, 2023
As we bid farewell to last year, it's time to take a closer look at what the future holds for the economy, stocks, and bonds. While Wall Street is notorious for forecasting positive stock prices each year, 2023 is proving to be different. Instead of the typical high single-digit returns and no recession, the majority of analysts are predicting a recession with stock market declines, followed by a recovery. The real question remains, when will the pain hit? Will it be in the first half of the year with a corporate earnings decline and the Fed coming to the rescue, or will the bear come out of hibernation in the second half? Timing is key in navigating this uncertain future successfully.
The Consensus View for 2023
Despite ending 2022 with a 19.6% decline, the S&P 500 is ready for a comeback in 2023 according to Wall Street analysts. With an average estimate of a 6% rally, the outlook is cautiously optimistic. The consensus shows 2% growth in earnings, with a potential increase of 11% or a decrease of 10% as the highest and lowest estimates. Despite the typically optimistic attitude of Wall Street, the expectations for 2023 are modest with a 4% increase in valuations and only 2% of the stock rally attributed to earnings growth.
Bloomberg Consensus Economic Forecasts
The 2022 and 2023 economic data estimates from Bloomberg are based on partial end-of-year figures. The consensus predicts a slowdown in real GDP growth, with 5.9% growth in 2021 slowing to 1.9% in 2022 and a mere 0.3% growth in 2023. Inflation is expected to decrease, moderating from 8% in 2022 to 4% in 2023. Meanwhile, Wall Street is forecasting a decline in job growth, with an average monthly increase of 374,000 jobs in 2022 stagnating to just an additional 1,000 jobs per month in 2023, and an increase in the unemployment rate from 3.6% in 2022 to 4.4% in 2023.
Bloomberg Consensus Economic Forecasts
The warning signs are clear as the unemployment rate faces a possible increase to 4.4%, an occurrence that has never happened outside of a recession since 1950. With the economic consensus putting the odds of a recession in 2023 at 65%, the highest since the Covid shock in 2020, it's no wonder both Wall Street and the Fed are preparing for a bumpy ride. The Cleveland Fed and New York Fed's recession models even show a 54% and 47% probability of a recession, respectively - higher than the readings for the past four actual recessions. The path of the stock market will heavily depend on timing the onset of the economic pain, as history has shown the Fed will step in to support the dual mandate of price stability and full employment when the focus shifts from inflation to employment. The timing of a market rally will also be influenced by the length of time between the Fed's last rate hike and the start of the recession.
The Window of Opportunity
The timing of predicting a recession and the Federal Reserve's reaction is crucial. We analyzed every recession in the past 50 years to understand the market's behavior after the Fed's last interest rate hike, the beginning of the recession, and the market's performance from the start of the recession to its lowest point. Our findings reveal that during the first two recessions, the S&P 500 saw mild returns of 3.7% and 7.9% respectively, as the recession started only two months after the Fed paused. However, during the 1973-1974 recession, the market fell by 42% from the start of the recession to its lowest point, as the Fed continued to raise rates during the recession. In contrast, the 1980 recession saw a milder 9% decline in the S&P 500, as the market initially rallied during the recession and the length of its decline was just under 3 months.
The timing of the Federal Reserve's rate hike and the onset of a recession has a significant impact on the stock market. Previous recessions, such as the 1990-1991 recession and the 2007-2009 recession, have shown that the stock market tends to have a stronger rally when the Fed's last rate hike occurs more than a year before the onset of a recession. This allows the market to believe that the economy has avoided a recession, leading to a rally, before the delayed impact of monetary tightening sets in. In both cases, the market went on to decline double digits before reaching a bottom.
It is crucial to consider the length of time between a Fed pause and the onset of a recession as this has a direct correlation to the size of the market rally. The longer the lead time, the larger the rally, and similarly, the longer the bear market continues, the greater the market decline. This is why determining the timing of a recession is so critical as it will impact the amount the market can advance once the Fed's last rate hike takes place.
According to the Fed futures market, the Fed is expected to hike interest rates by an additional quarter point (25 basis points) on March 22nd, driving the Fed Funds Rate from its current 4.5 - 4.75% rate to 4.75 - 5.0% by the spring. With this expected policy path, the question now is not whether the economy will fall into a recession, but rather when. Those who predict a recession in the near future or within the coming months are in the "first-half-pain" camp, while those who believe a recession is not likely until the second half of the year anticipate the market to rally for the next six months before being affected by the historical trend of a recession driving stock prices lower.
Get It Over With! - The Case for Early Pain
The question of whether the U.S. economy will slide into a recession or manage to hold off until the latter half of the year is dependent on the changing economic winds. The economics team at Piper Sandler reported that 75% of the consumer spending growth in 2022 came from depleting savings and that this trend is unlikely to repeat in 2023. This supports the argument for a continuing economic downturn leading to a recession.
Data shown in the top panel displays the growth of retail sales, which saw a rapid increase of more than 25% at the end of 2021 due to consumer spending of government transfer payments. The bottom panel displays the U.S. personal savings rate in black and credit card debt growth in red. During the pandemic in 2020, the savings rate skyrocketed to over 30% and credit card debt fell by 11% in early 2021, compared to the previous year. However, retail sales growth continues to decelerate and what drove that growth in 2022 was not healthy by any stretch of the imagination. The consumer savings rate has plummeted from double digits to the lowest rate (2.4%) since the late 1950s, and credit card debt has experienced the largest increase in a quarter century!
It is widely understood that consumers have been impacted by the spike in inflation, which reached a 40-year high, and the decline in their spending power as wages failed to keep pace. This has led to a reduction in the personal savings rate and an increase in the use of credit cards. The history of the US personal savings rate, dating back to the late 1950s, highlights the fact that the current rate of 2.4% is not far from the all-time low set in July 2005 at 2.1%. Moreover, it is important to note that during recessions, consumers tend to tighten their wallets, as seen by the rise in savings. If a recession is on the horizon this year, as predicted by many, it is more likely that the savings rate will increase from its current level, leading to a decline in retail sales rather than further growth.
The bear case for the economic outlook in the first half of 2023 is based on the continued decline of the housing market, in addition to the reversal of economic tailwinds from 2022. Despite a decrease in 30-year fixed-rate mortgage rates, housing affordability remains poor and is even worse than the peak of the housing bubble in 2006. The current Housing Affordability Index, created by the National Association of Realtors, is at the lowest level ever recorded, further supporting the bear case.
The two primary determinants of housing affordability are home prices and mortgage rates. Unless we see a dramatic decline in mortgage rates or a significant hit to home prices, a turnaround in housing is unlikely to occur any time soon. Housing is one of the best leading indicators for the economy as it has always peaked before a recession, so if housing continues to decline and the economy can’t count on the US consumer to support it, then the U.S. economy may already be in a recession or likely will be soon. Therefore, any market rally if one comes on the “hope” of a Fed pause as the economic data comes in weaker than expected, would likely prove short-lived with weak returns.
The Glass Is Half Full - Delayed Pain
According to those who believe the US economy can avoid a recession until the end of the year, there are a few factors contributing to their near-term optimism. The most significant of these is the substantial decrease in gasoline prices, which had taken a huge toll on consumers' wallets. In mid-June of last year, the daily national average gasoline price reached an all-time high of $5.02 per gallon, but has since dropped to almost $3 per gallon. This reduction in gas prices is providing a much-needed financial boost to consumers and has also positively impacted consumer sentiment, which tends to move in the opposite direction of gas prices. When consumer sentiment is high, it often leads to higher retail sales, which are a critical component of the US economy. As such, the relief brought about by lower gasoline prices could keep the US consumer going for a bit longer.
Further, a tell-tale sign of a coming recession is that initial unemployment claims begin to rise dramatically, indicating an eroding employment picture. On average, initial claims precede the official unemployment rate by 4 months. Currently, the low level of initial claims suggests that the unemployment rate should remain stable at least until May. Despite recent large layoff announcements by US tech companies, small businesses are retaining their employees. In fact, job openings posted by companies with 10-49 employees are near their all-time high. However, there has been a decrease in job openings posted by mid-sized firms with 250-999 employees, as well as large companies with 1000-4999 employees who are trying to maintain their profit margins amidst high inflation.
Another development that could further support the US and global economy near-term is the reopening of the Chinese economy after three years of strict lockdowns, as the following article highlights:
China’s Holiday Rebound Points to Upside for Global Oil Demand
Gasoline and jet fuel consumption jumped during the week-long break as people took the opportunity to travel after the nation dismantled its restrictive Covid Zero policy last month. Trips exceeded those of the pandemic years, but were still below pre-virus levels…
More than 300 million trips were made over the holiday, nearly 90% of pre-pandemic levels, according to the Ministry of Culture and Tourism. Retail gasoline sales at filling stations affiliated with China Petroleum & Chemical Corp. — the nation’s biggest refiner — were 20% higher than the corresponding period last year.
As China's economy returns to normal, there will likely be a boost in exports to China and a positive impact on global growth. This increase in US exports to China could temporarily counteract the effects of the Federal Reserve's monetary tightening in the US, but it is unlikely to prevent a recession entirely. Rather, it may only delay the inevitable economic downturn that lies ahead.
Portfolio Strategy
When evaluating changes to our investment strategies, we often compare them to our asset allocation benchmarks. We designed our benchmarks for our investment objectives to mirror that of Blackrock’s, which is one of the world’s largest wealth managers, and shown below for reference.
We want to highlight our benchmarks above to help frame the two most important decisions for our firm to make each year:
- How much to allocate between stocks vs bonds
- How much to allocate to domestic vs foreign investments
Between 2000 and 2022, the average yearly performance difference between the S&P 500 and the Bloomberg US Aggregate Bond Index was 15.2%. This highlights the significance of making the right asset allocation decisions between stocks and bonds. During the same time frame, the difference in annual performance between the S&P 500 and the MSCI All World Ex-US Index was nearly 10%, emphasizing the importance of allocation decisions between domestic and foreign stocks.
Given our view that there is still economic uncertainty ahead due to the incomplete impact of the Fed's tightening last year, we maintain a below-neutral allocation to stocks compared to our benchmark and higher levels of cash. We also have exposure to commodities, including precious metals, as we expect central banks to end their tightening policies this year. We anticipate a decline in the US dollar, which would benefit commodities and foreign stocks, leading us to slowly increase our exposure to these areas.
While the majority of strategists this year hold to the early or late pain outcomes, we believe there could be an in between scenario and is why we want to remain nimble. In the “Window of Opportunity” section above, we pointed out that the S&P 500 typically rallies after the last rate hike until a recession begins to form. The end to the Federal Reserve's rate raising cycle, which has been indicated by the slowing of inflation and the dissipating of job growth, is seen as a positive sign by the stock market. This has led to a recent increase in the stock market, as investors see a potential end to the economic challenges and a return to stability. With the official Fed pause still ahead of us, we could see the market climb a little further before the onset of a recession hits. This is why the accounts are not positioned for minimum risk at this time. However, should we begin to see market internals begin to deteriorate, we will start raising cash and move back towards a minimum risk posture once more.
In a follow-up newsletter, we will delve deeper into commodities and the fiscal position of the US government, and how last year marked a major tipping point in our view. As a preview to the next newsletter, we leave you with this fact:
In 2022, the S&P 500 index declined by 25% while the Bloomberg Long-Term US Treasury index fell by 29% at the October 2022 bottom. This is the only bear market in stocks (20%+ decline) in which long-term US Treasuries fell more than stocks did since 1970. On average, long-term US Treasuries have beaten stocks by 42% during stock bear markets.
Should you have any questions, please do not hesitate to reach out to your wealth advisor.
Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.
Copyright © 2023 Chris Puplava