By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
July 18, 2022
To say that the first half of 2022 was rough would be an understatement. Just about the only place to hide was in the energy sector where West Texas crude oil was up 39% in the first half. On the flip side, the Bloomberg Barclays US Aggregate bond benchmark was down 9.62%, long-term US Treasuries fell 20%, and the S&P 500 fell 20.5% while the NASDAQ fell 30%. To put these sharp declines into perspective, consider these jaw-dropping stats provided by Goldman Sachs on what took place the first six months of this year:
GS Tactical Flow of Funds: 1H Recap
- The US 60/40 “World’s Retirement Portfolio” just logged the second worst start to the year since 1900, that is 122 years. (-17%).
- The worst start to the year in the past 122 years happened during The Great Depression in 1932 (market bottom July 8th, 1932).
- US bonds had their worst start to the year on record dating back to 1900.
- The S&P 500 logged its worst start since 1970 (Richard Nixon was president 52 years ago), and the 4th worst start on record—only 1932, 1962, and 1970 started off worse.
- Past performance is certainly not indicative of future returns, however in 1970 the S&P closed unchanged and rallied +27% in 2H, 1962 rallied +15%, and 1932 +56% in 2H.
- The last 4th of July, investors were opening their half-year statements with a +14.41% gain for the S&P, and the 60/40 hasn’t seen a down first half in the past 11 years.
- My biggest risk for 2H is that investors have not seen their 1H half statements and decide to reduce risk.
- There have been no unwinds from the largest and most important owner of the market, and I don’t know if that is common knowledge for folks that don’t have Bloomberg IB or watch CNBC.
With stats like this, is it any wonder that sentiment is probing record lows no matter who you survey? Whether it be CEOs/CFOs of large businesses, small business owners, investors, consumers, all these groups are showing sentiment typically only seen in the context of a recession. One of the eye-opening releases this week came from the National Federation of Independent Businesses which surveys hundreds of small businesses each month. One of the survey questions asks business owners their views on the economic outlook and the reading for June was the worst reading on record going back to the early 1970s. Think about that, business owners are seeing the current outlook as worse than what they faced during the Great Financial Crisis of 2007-2009, worse than when they were forced to shut their businesses down during COVID and yet expected to continue to pay their bills. The drop in their outlook is absolutely stunning and shown below.
When we look at why consumer sentiment levels are at their lowest levels in decades, it’s easy to see that consumers’ standard of living is being assaulted by runaway inflation which is leading to the biggest decline in real hourly earnings since the 1970s as inflation clocked in at a 9.1% annual rate in June. Highlighted in red below are periods which saw sharply rising inflation and declining real wages for the US consumer.
Inflationary surges typically burn themselves out as they crush consumer’s discretionary spending and corporate profits. Often the inflation rate peaks during a recession as an economic slowdown brings with it disinflationary forces as consumers and businesses reduce demand and prices begin to fall. Earlier this year, we showed the news search results for the number of articles where “inflation” was in the headline and we were seeing a sharp pickup while “Covid” keywords in headline stories were falling. Our view was that as the economic slowdown picked up speed, we would begin to see the word “recession” in more headlines as its reality came more into view and with it we would likely see more headlines with the words “bear market” in them as stocks reflect the souring economic reality. As shown by the story counts for the words “inflation” (white line), “recession” (blue line), and “bear market” (orange line) below, inflation continues to dominate the public psyche but what is also noteworthy is that recessionary fears are quickly building and almost at the levels seen during the Covid-induced lockdown recession of 2020.
The broadest measure of economic growth widely used by economists and investors is the Gross Domestic Product (GDP) measure that the government puts out on a quarterly basis with a lag. Economic textbooks define a recession as two consecutive quarters of negative GDP and by that definition we are likely in a recession right now as the first quarter GDP came in at -1.60% and the current Atlanta Fed estimate for second quarter GDP is currently tracking at -1.5%. Later this month, the Federal Reserve is going to find itself between a rock and a hard place as the consensus was for a 0.75% rate hike at their July 27th meeting but after the hotter-than-expected June CPI print of 9.1%—a 41-year high—investors are now starting to bet on a possible 1.00% rate hike. The last time the Fed raised rates that dramatically in a single meeting was February of 1989.
What could be very uncomfortable and plastered all across the newswires is if the very next day after the Fed meeting we get the second quarter GDP print and it comes in negative. You can imagine the headlines that will likely arise such as:
- “Fed Raises Rates Aggressively Despite US Economy Falling into Recession”
- “The Fed Induced Recession Is Here”
- “Fed Sacrifices the Economy on its Monetary Altar to Break the Back of Inflation”
- “The Fed Will Eventually Kill Inflation, But It’s Already Killed The Economy”
Our firm’s view is that we are either in a recession now or will be staring one in the face before the end of the year. Heading into 2022, we saw the likely headwinds facing the economy and stock market as both we and the consensus expected the Fed to begin raising interest rates this year as well as end its money printing. While we expected inflation to heat up this year, what we did not envision was the dramatic rise in inflation to levels not seen in nearly a half century that would prompt the Fed to raise rates in the most aggressive campaign since the 1970s. In our January newsletter, we wrote the following:
Most Recent Data Shows a Large Withdrawal in Market Liquidity Underway
While economic growth is likely to remain positive in 2022, we are seeing a large withdrawal in market liquidity coming from several sources: Fed QE is ending, REPO facility is exploding to nearly $2T, and the US Treasury will be increasing its reserve balance at the Fed… The loss in liquidity should bring down market multiples and possibly lead to a correction in H1 2022. A correction would help provide cover for the Fed to take a more accommodative stance and set the stage for a relief rally in the back half of 2022.
Going into 2022, we had a large cash position, exposure to the energy sector, materials, and precious metals as inflation hedges, and in terms of fixed income, we had a minimum weight towards the asset class as well as a sharply reduced average maturity as we anticipated interest rates to rise this year. As our thesis began to play out where stocks and bonds were both declining, we began to see value appear. As the year progressed and inflation spiked to uncomfortable levels, it became clear that the path of monetary policy was going to be more restrictive than initially thought. This in turn impacted our outlook for the markets and economy where we turned more cautious, raised more cash, and increased our risk-assessment of recessionary impacts.
Keep in mind, recessions are typically inflation killers as demand falls enough to pull down overheated prices, ultimately leading to a peak in interest rates. Recessions impact every facet of the economy, which is why we recently reviewed all of the recessions since 1969 to see the typical impacts on key fundamental data points. Here's what we found:
- Average trough in the ISM Purchasing Managers Index = 36.43
- Average decline in US payrolls = 4.09%
- Average decline in real personal income = 3.6%
- Average decline in GDP = 3.1%
- Average decline in S&P 500 earnings per share (EPS) = 27%
- Average price decline in the S&P 500 = 32.7%
When we look at the current levels and measure the decline to the average seen in recessions we get the following:
- ISM needs to fall 16.6 points from its current level (indicates we still have a long way to go)
- Current employment of 152 million people implies potential loss of 6.2 million jobs
- Current real income of $14.5 trillion implies income loss of $522 billion
- Real GDP is down 0.40% from its 2021 highs, implies a further decline of 2.8% from current levels
- Current trailing S&P 500 EPS of $199.79 implies a decline to $146.02/share
- S&P 500 is currently down 21% from its highs, implying a 15% decline from current levels to get to average
Some strategists have argued that the current decline in the S&P 500 has already discounted a recession and now presents an attractive valuation. However, should the S&P 500 see its EPS fall 27%, the average decline during a recession, the current 18.99 valuation would disappear and shoot up 37% higher to 25.96. Outside of the COVID recession, that would be the highest P/E ratio seen since the Dot-com bubble two decades ago. While the market is priced for an economic slowdown, it is clearly not priced for a recession.
As mentioned above, as the outlook has changed, so too has our strategy. Given the largest decline in long-term US Treasuries (USTs) seen in over a half century and the fact that long-term USTs typically post double-digit rallies during recessions, we felt it prudent to begin hedging the portfolios against recession risk with the purchase of the iShares 20+ Year Treasury Bond ETF (TLT). We scaled into the position as both interest rates and inflation rates were rising and we are more or less flat on the position. We feel it will perform well should the US economy decline further ahead as we expect.
What has been incredibly disappointing this year is the performance of gold and silver in the face of the sharpest inflation spike this country has seen in 41 years. One of the primary drivers of gold’s weak showing this year has been the strong performance of the USD. The only currencies that have gained ground on the USD this year are the Russian Ruble (up 26% YTD) and the Brazilian Real (up 2.7% YTD). When foreigners look at gold they see a different picture. For example, here’s how gold has performed in various major world currencies year-to-date (as of July 14):
- 13% in Japanese Yen
- 9% in Swedish Krona
- 8% in Norwegian Krone
- 6% in British Pounds
- 6% in Danish Krone
- 6% in Euros
While it has been both painful and disappointing to hold gold and silver this year, we are maintaining these positions as the USD will eventually decline once the Fed begins to worry more about economic growth and less about inflation. We see this reality shaping up in the months ahead and will hold fast to our metals positions.
We have conducted extensive research around how various asset classes like gold, stocks, and bonds perform around recessions, which we would like to present as it helps to explain our current positioning. As well, we feel there is a major disconnect occurring in the energy markets, which we will provide research on in forthcoming notes. However, this newsletter is getting long and we will instead present our analysis in a follow-up newsletter. Should you have any questions, please do not hesitate to reach out to your wealth manager.
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 © 2022 Chris Puplava