I checked off a key bucket list item several weeks ago: an eighteen-day Italian vacation. The experience exceeded my high expectations. I personally played travel agent and the family gave me high marks for our busy itinerary with only a few small hiccups.
We saw Springsteen in concert in the Rome venue where the chariot races were held a couple millennia ago and really enjoyed the entire Rome experience. We then visited Florence, Cinque Terre, Tuscany, Pompei and the Amalfi Coast before returning home, exhausted but deeply enriched by the experience.
I faced a tense professional problem for the brunt of the trip though: The US debt ceiling saga. We landed in Rome on May 19th and pundits were projecting the US would default on its debt obligations on or about June 1st.
Talk about horrible optics: Global financial markets descend into chaos while our clients’ wealth advisor is frolicking on the Italian coast! Given the extra toxic political environment these days, I feared a debt default event would occur and exhaled when a last-minute deal with cut. It was a razor close brush with financial calamity.
As I’ve shared with my politically conversative clients and friends, defaulting on the US debt is not the hill to die on. You join the fight before the money is spent during budget negotiations, not when it comes time to pay the debt. Trust me, you don’t want to live to see a default on what is referred to as the “risk-free interest rate”.
As we enter the dog days of summer, there’s a welcome stock market rally underway and promising inflation news. I submit the current market run is an optical illusion, showing all the earmarks of a classic bear market rally. Consider these facts and circumstances:
- The Fed Reserve is still embarrassed by their gross misreading of inflation risks in 2021. They have been forced to over-react with a flurry of short-term interest hikes in a scramble to stem out-of-control inflation. While future rate increases may slow, even cease, the Fed will leave the current elevated interest rate regime in force indefinitely to ensure inflation has been tamped down. The economy has yet to feel the full effects of this violent rise in short-term interest rates; it’s coming.
- Complicating matters the Fed is also intentionally reducing the nation’s money supply to reduce its bloated balance sheet, which is another major economic headwind.
- The Fed Reserve’s manic rate hikes has caused real damage to the US banking system. The bank failures last spring were scary but (so far) have been isolated to mismanaged organizations and not a systemic contagion like 2008 or the 1930s. However, the entire banking industry is reeling in these challenging financial conditions.
- Uncontrolled inflation has generated substantial unrealized losses in banks’ investment portfolios. Higher interest rates are causing pain in the US commercial mortgage loan sector as well; most of these loans are held by small-to-mid sized banks. Lastly, high short-term investment yields are leading to bank deposit flight, causing even more financial headaches.
- These conditions are already leading to a contraction in aggregate bank lending, which could lead to a deeper recession than the one already coming down the track. I admit that bank stress was not on my radar as a major market risk heading into 2023; now it is.
- It’s a plain fact that bond investors are predicting an economic recession is on the horizon. An inverted Treasury bond yield curve is historically one of the best recession signals and it has never been more inverted than right now.
- The economy remains in decent shape, due to a booming labor market. However, there’s growing evidence the economy is starting to cool. Lingering inflation effects are reducing consumer spending, higher interest rates are curbing lending activity and, starting in the fall, student loan repayments, suspended since COVID, will restart. These factors will take a bite out of the American consumer’s spending budget, which is 70% of the US economy.
- Many signs are pointing to an approaching recession; the questions are when it will begin and its severity.
Economic recessions are natural and even healthy for an economy to reduce inflation, clean up past excesses and reset for future growth. The problem is the stock market detests them and they create outsized market volatility.
As a recession barrels in our direction, current stock market values are uncomfortably elevated, even before the recessionary impact on earnings. It will be interesting to hear corporate CEOs provide earnings guidance in the coming months.
So, what should an investor do with a recession on the doorstep? My message is to plan to muscle through it because there’ll be rewards on the other side.
The fact is one cannot successfully time recession risk. It’s useful to re-peruse the statistical charts that quantify the material penalty for sitting on the sidelines when stock prices burst upward. Missing out on just a few of the best market days has an outsized effect on longer-term stock returns. If invested in stocks now, stay invested in an actively managed, nimble portfolio poised to capitalize on investment bargains that will arise from future market volatility.
Lastly, we’re encouraging clients to add to their bank’s misery by withdrawing their abysmally low-yielding excess bank deposit assets and invest in super-short investment grade debt to earn a healthy yield with immediate liquidity. These outsized investment yields should stick around for a while providing an attractive risk-adjusted return plus dry powder capital to invest in riskier assets once the bear market returns. Longer-dated bonds can serve as a recession hedge, but their current yields are quite boring compared to short-term bonds.
Looking forward, I’m optimistic the Fed Reserve will turn away from its ill-advised zero interest rate monetary policy that has caused many market bubbles and distortions since 2008.
Hopefully, once the recession clears, short-term interest rates will settle at more normal levels so cash can once again serve as a viable asset class.
Until next time, ciao!…Tim