Portfolio Construction in a Slowing Economy

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
April 3, 2022

Summary

Inflation and aggressive monetary tightening could tip the U.S. economy into recession. A European war increases this risk.

“Soft Landings,” where monetary tightening avoids recession, have happened three times in the last eleven tightening cycles.

Avoiding a deep recession is bolstered by a strong labor market and employers that will be loathed to let go of employees they found hard to find during the reopening.

Current portfolio construction adds a significant amount of recession hedging companies that have historically done well during downturns while still performing well during normal times.
Recession Risk: What are the Odds?

Spiraling inflation and an aggressive monetary policy tightening cycle by the Federal Reserve could be enough to tip the U.S. economy into a recession even in the best of times. Add an Eastern European war and the risk of downturn spikes.

Major economic forecasters see a roughly 33% chance of a recession within the next 12 to 18 months, not-insignificant odds which have doubled since Russia invaded Ukraine in late February. That’s due, in part, because history shows the Federal Reserve doesn’t have a stellar record of avoiding a recession when it hikes interest rates.

Guiding the economy to a safe landing amid mounting turbulence—including an oil price shock, severe geopolitical risk, and a flattening yield curve—would be the most extraordinary policy maneuvers in the central bank’s recent history. But the Fed does have a significant factor in its favor: the U.S. economy remains fundamentally strong. Consumers are flush, and businesses are in hiring mode. Some economists and Fed officials contend that could be enough for it to withstand a series of interest rate increases.

Russian Shameful Invasion of Ukraine Provides a Twist

The compounding factor is the Russia-Ukraine war, which could keep oil and other commodity prices elevated for months and bring down global demand. A prolonged period of higher oil prices would mean U.S. households are forced to redirect spending from discretionary goods and services to necessities—gas and groceries, primarily—which slows the economy.

Before the invasion, when we were only talking about policy normalization at the Fed, we were thoroughly convinced the economy could absorb what the Fed was planning to do. While that’s still a possibility, we are uncertain about the external shock that has little to do with economic or financial fundamentals and everything to do with geopolitics.

At the same time, continued supply chain disruptions stemming from both the war and Covid-related factory shutdowns in China could keep prices elevated even longer. All of which would lessen the chances that the Fed will be able to handle inflation soon.

The U.S. remains more insulated from the impact of Russian sanctions than Europe. But still, if there’s significant global financial market stress above and beyond what we’re seeing today, or if there’s a substantial deterioration in global economic conditions, it’s hard to know how the U.S. economy entirely escapes financial hardships brought on by this war.

We will likely see, at least, a partial default on Russian sovereign debt, which may spill over into Russian corporate debt, as well. Although the U.S. and European financial systems appear to be well insulated against such an occurrence, it is only in default when you find out where the interlinking relationships exist. For example, during the last Russian default in 1998, the U.S. Federal Reserve was forced to intervene when the collapse of the U.S. hedge fund, Long Term Capital Management (headed to no less than two Nobel Laurates), posed a systemic risk of cascading defaults spilling over into the financial system.

Time to Prepare for an Economic Slow Down

At the center of the debate over whether it’s time to prepare for a recession is the Fed and its indication that it plans to raise interest rates at least six more times this year to slow down rising inflation—and officials have recently hinted they could move faster than that. Steep rate-hike cycles have historically been catalysts for economic downturns because moving aggressively to slow the economy carries an inherent risk of going too far, stalling growth, and increasing unemployment.

In the last 11 tightening periods, the Fed has just once nailed a “perfect soft landing,” which came in the early 1990s. But twice more, in the mid-1960s and early 1980s, the central bank raised interest rates without sparking an official recession—and such soft landings are not as rare as the business media is leading you to think.

Still, eight recessions out of 11 tightening cycles are the reason for concern. Moreover, some economists say the risk now is significant because the Fed waited so long to act on inflation—consumer prices have risen 7.9% year over year and are expected to keep climbing—that it must now tighten quickly to get things under control. That, in turn, could carry a greater chance of overdoing it.

Mitigating Factors

Despite the mounting risks facing the U.S. economy at home and abroad, there are several reasons to believe the economy could grind on even amid a tightening and uncertain environment. First, the labor market is solid, with record job openings, sustained demand for workers, a rising labor-force participation rate, and unemployment falling to 3.8%, just 0.3 percentage points above its pre-pandemic low.

American consumers remain healthy, too, even as the cost of living rises, and an estimated 60% of households continue to hold on to excess savings built up during the pandemic. At the same time, home and stock portfolio values have soared, and overall household net wealth climbed more than 37% between the first quarter of 2020 and the fourth quarter of 2021, Federal Reserve data show. Growth has been so strong that even a sizable slowdown this year could still leave the economy humming along.

Current GDP Forecasts

Current GDP forecasts reflect higher commodity prices and tighter financial conditions and have been lowered to 4% growth for 2022, down from 4.6% at the start of the year. That’s a good chunk that we’ve taken out of growth to reflect recent developments, but you look at that 4% figure, and it’s hard not to see an economy with a buffer to absorb additional shocks and higher interest rates.

The hope among some economists is that the economy’s underlying strength will be enough to keep any recession relatively shallow and short-lived, if not fend it off entirely. Even if we see a slowdown, we expect it to be of the “garden variety”—nine to 12 months of a household-driven contraction sparked by a decline in consumer purchasing power, lower housing purchases, and a contraction in business capital spending.

Layoffs Will Be Lower Than Normal IF the Economy Slows

Tempering the pain is likely to be the U.S. labor market, where employers, who have spent more than a year competing to hire and retain workers, are unlikely to let them go amid a mild slowdown or recession. The layoff rate hit an all-time low of 0.8% in December. It climbed only 0.1 percentage point in January despite the Omicron-induced economic shutdowns and government data show—a possible signal of how employers might react to the subsequent slowdown. A delay in widespread layoffs would minimize the hit to employment, thereby limiting the damage to consumer demand and the broader economy.

Still, while the economy for now looks steady, the level of uncertainty around the world means the status quo could change quite quickly. Therefore, we need to be cautious in avoiding overcomplacency based on what we perceive to be a balanced situation today.

Portfolio Construction: Prepared for an Economic Slowdown

The yield curve refers to the difference in yields between differing maturities of Treasuries. Normally, short-term bills, with maturities measured in weeks or months, pay less interest than longer-term notes and bonds, leading to an upward-sloping curve. However, longer-term yields are sometimes lower than shorter-term rates, an inversion that often signals a looming recession.

Not all inversions carry the same weight. For example, the yield on the five-year Treasury recently rose above the 30-year, which offers little information. However, the two-year yield rising above the 10-year has historically been a sign that an economic slowdown is coming, though still months away. This past week, the two-year closed at 2.43%, while the 10-year closed at 2.374%.

While the first inversion gets all the attention, it’s the second one they need to worry about. The yield curve often inverts and returns to its normal shape before reverting again. This time, the yield curve could revert to a normal upward sloping shape due to the Fed unwinding its massive bond-buying binge over the past several years. This so-called “quantitative easing” reduced intermediate and long-term interest rates. However, as they unwind these positions and sell them back into the market, this will have the opposite effect of increasing the supply of bonds for sale, reducing their price, and increasing interest rates across the intermediate-to-long end of the yield curve. This will cause the yield curve to take on a normal, upward-sloping shape.

A yield curve inversion doesn’t cause a recession. Instead, it’s simply a sign that the economy is fragile enough for an outside event to trigger a slowdown. That was the case in 2001 when the popping of the dot-com bubble and 9/11 caused the recession, and in 1990, when Iraq’s invasion of Kuwait did. So inverted curves mean ‘be careful’.

Being careful could mean dumping stocks and going to cash, but that might be too careful—and it ignores the fact that inflation is eroding the value of money as we speak. Another option would be to buy the stocks that have historically performed best during recessions. We look for recession beneficiaries at least in the middle third of their sectors during expansions which are both recession and expansion beneficiaries. So, there’s a little bit of offense to go with the defense.

Today, we have almost 22% of our core equity portfolio in these “Recession Hedge” companies, including healthcare stocks Abbvie (ABBV), United Health Care (UNH), and Pfizer (PFE), as well as consumer staples stocks such as Proctor & Gamble (PG), Dollar General (DG) and Target (TGT).

Approximately a third of the portfolio is in our Core equities, consisting of reasonably priced wealth creators that generate high Free Cash Flow Return on Investment (CFROI) and high asset growth. Names in this group include Amazon (AMZN), Apple (AAPL), Google (GOOGL), Microsoft (MSFT), and Visa (V).

Our next largest segment is the Value names which focus on inexpensive firms, offer ample upside based on our Discounted Cash Flow Analysis, and trade at low multiples. Firms in this group include Meta Platforms (FB), Netflix (NFLX), and PayPal (PYPL).

Next, our Growth segment seeks out companies with exceptional growth attributes with sustainable Economic Margins, such as Nvidia (NVDA), Adobe (ADBE), and Palo Alto Networks (PANW).

The balance of the portfolio consists of more short-term themes in stocks that will benefit from Infrastructure spending (United Rentals-URI), Oil stocks benefiting from the run-up in this commodity’s price (Chevron-CVX, Devon Energy- DVN), stocks that have and will continue to benefit from the reopening of our global post-pandemic economies (Disney-DIA, Booking Holdings-BKNG & ABNB), and large U.S. financial stocks that have been taking market share from this European competitors and have little, if any, exposure to Russia (JPM, Morgan Stanley-MS & Goldman Sachs-GS).

Catching Up

We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet in person or by a Zoom/MS Teams video link. If you would like to get something on the calendar in the interim, please send me a note with some dates and times.

Warm regards,

John