Please enjoy this edited transcript of the UMB Private Wealth Management Investment team’s second quarter 2023 economic webinar.
We all heard the word unprecedented during the global pandemic (too often, some say). Here we are, once again, seeing unprecedented economic activity.
It has been an interesting couple of months. The Fed has continued to hike interest rates to control inflation in ways we haven’t seen before. They hiked during financial turmoil, they hiked when the yield curve was steeply inverted, and they hiked when liquidity has been contracting.
We’ll talk about this Fed action, what makes it unprecedented, and what we think is going to happen going forward. We’ll then review some of the economic fundamentals in our recession indicators, to see what we’re thinking as far as a soft landing, bumpy landing, or a hard landing.
Fed actions and recession indicators
Typically, the Fed gets blamed for causing recessions, and perhaps that’s rightly so. Late in the economic cycle, things start to heat up, inflation starts to heat up, and suddenly, the Fed hikes interest rates at the end of the cycle—perhaps causing the recession.
All economic cycles have some similarities, yet every economic cycle has its own set of nuances. What’s interesting today is you can see how the Fed walks along with the economy, controlling inflation, controlling growth, and then pauses because they know there’s a lag effect.
The Fed needs to let the economy digest higher rates, and they pause long before that recession.
In the last 40 or 50 years, once the dust has settled, the Fed has started easing before the onset of the next recession. They’ve hiked, they’ve done a little bit of a pause, and they’ve seen the economy start to roll over, so, they typically go into easing mode before we’re actually in recession. That might be a little bit different this time based on the below factors:
- Fed funds effectively at zero for the better part of the decade
- Negative real rates for a long time (“easy” money)
- An unpredicted global pandemic
- The unusual speed of rising rates in the last four or five cycles
- Banking turmoil
We’re just now entering the period where we’re going to find out what these unprecedented moves are actually going to do to the economy. It’s a really important time that we’re entering now over the next three to six months, how much impact have these unprecedented moves had?
We foresee a bumpy landing and a mild, short-lived recession later in 2023, and we believe an economic pause is coming.
Banking industry volatility and deposits
Spring 2023 had several sudden banking industry events, including the failure of several U.S. banks. We don’t want to say there was good news with the banking turmoil, but one of the ultimate results of it is it probably is doing some of the Fed’s work for them. A lot of deposits left the banking system, and we had a drop in the growth rate of deposits.
Deposits tend to grow over time in line with economic growth. We had a spike in banking deposits during COVID and shortly after – a massive increase in the growth of bank deposits. Then we had this bank turmoil, and we saw a very rapid decline. For the first time in about 50 years, we had declining bank deposits.
There was room for those deposits to fall, there was room for that to happen, but it was a very unprecedented decline. We know banks and credit are the lifeblood of the economy. If banks don’t have deposits, they can’t lend, and that’s why you’re starting to see tightening of lending standards now.
Again, there was probably room for lending standards to tighten, but when it tightens this dramatically, it is almost certain to slow economic activity. This should maybe slow down our expectations for how far the Fed’s going to have to go. We’ll have to see how much impact it has on the economy as the next six to nine months unfold.
Lastly, unpacking our theme is the Fed hike when we saw money supply or liquidity contract. We haven’t seen that before. The M2 growth is nothing more than a measure of cash liquidity in the economy. Over on the right hand side of the graph you can see through the global pandemic, we had a spike in liquidity, which really helped economic activity as well as financial markets and all of a sudden with quantitative tightening now and other bank lending standards tightening, all of a sudden you’re going to see M2 growth slow. Last month we saw a contraction of 2.4%. The forecast is for next month, a minus 5% contraction year over year, which will be the largest contraction in liquidity or M2 growth since the ’30s.
It is an unprecedented drop in money supply growth, and that always gets everyone’s attention, and that’s fair but we have room for that drop off because we had that massive unprecedented increase. There’s room for money supply to taper off without it being a crisis yet, but we have to pay close attention to it.
Prepared for landing that this will impact economic activity, slow the economy and have some type of slowdown for a mild, short recession let’s say in the second half of 2023. Another one of our issues data points, which was unprecedented, is the Fed actually hiked when the yield curve was significantly inverted. Historically, we’ve seen inversions in the yield curve. The Fed stops once the yield stops hiking, once the yield curve becomes inverted.
Through our investing lifetimes, the Fed has stopped because the bond market tends to move pretty early and is a pretty good indicator of if trouble’s coming for the economy. Yield curve gets pretty severely inverted and the Fed is typically done tightening at that point in time. This is an unprecedented cycle. The yield curve inverted quite dramatically, more dramatically than we’ve seen in a very long time, and it did it several months ago when this inversion started. Despite the severity of the inversion, we were just in the early stages of the Fed tightening and the Fed has kept tightening causing the inversion to get worse.
It made the unprecedented nature of this just get more and more dramatic. It is something we absolutely have to pay attention to. It is a very good indicator that there’s a recession coming. Now, the severity of the inversion this time, because all the other contributing factors are so unusual, it doesn’t automatically mean that we’re headed for a very severe recession, right, but it clearly indicated we have to pay attention to, and we have to know that a recession is coming our way. The magnitude of it is probably a more nuanced argument.
Is a recession coming?
What’s interesting is once the yield curve became inverted, the Fed paused. Then it took 18 months before the recession showed up. There is that lag, right? We know that the yield curve is, you cited in this cycle in the 2 to 10 yield curve, 2-year to 10-year inverted back in July of last year, then followed by the 3-month to 10 year in October, and so on.
Those similarities might play out if you see that recession towards the end of the year. It’d be very similar to other cycles. Now the other thing is, just a reminder, you’ve seen this data before. This is one of our recession indicators. Typically, when you do get that inversion on the yield curve, a recession’s coming. This is one of our favorite indicators, the leading economic index (LEI). This is a composite of 10 leading economic indicators, all compiled into one index, and the reason we like it, it has virtually a perfect track record of predicting oncoming recessions.
Once the data gets below -3.5, all of a sudden you’re headed into a recession. You can see a -7.1 again supporting our theme of a bumpy landing and the timing should be right towards the end of the year because it inverted a few months ago. That is another similarity we might see in this economic cycle.
Labor market indications
One variable which is sending mixed signals, is the labor market. It answers the question, are we in a recession now? This could be one of the nuances in this cycle. You can see that the unemployment rate starts to go up right about the same time you see a recession, so not a leading indicator, but really there’s no indication of that moving up at all. We’ve been stuck in this range of 3.5 to 3.7 for a number of months.
Even though we’ve heard about announced layoffs and things like that, it does not seem to come through in the data. Unemployment remains low. Of course, if people are gainfully employed, they more than likely will not change their consumption behavior supporting a slowdown not a severe recession. When you’re in a recession or entering in a recession, you start to see unemployment go up and you start to see payroll growth go down.
Maybe you see payroll growth slowing a little bit, but it doesn’t seem to be indicating that we’re anywhere near a recession as we speak, but we’ll watch this closely as we go through the remainder of the year. We watch initial unemployment claims very closely and then continuing claims.
In this cycle, one of the nuances might be we could have a job-full slowdown a recession versus a jobless recession. That would support as more and more people are employed, you don’t have a severe recession, you have a mild short-lived recession because it was hard to find qualified people. Perhaps in this cycle we won’t be so quick to have significant layoffs. These variables support a slowdown coming, but we’re not in a recession as we speak.
Unprecedented moves in the first quarter
We’re hoping that everything we’ve talked about indicates that we’re nearing the end of the Fed cycle, and I think mostly the world agrees. We’ve risen up to 5%. They were tightening very, very rapidly and then they dropped the size as it moves down to 25 basis points, and that’s a step-down. That was the first big signal we got from the Fed that tells you that maybe they’re getting to the end of the cycle. We’re currently at 5%, the dark blue line stops there. Are we in a pause or is there one more move? I think we’re in a consensus now. Probably one more move in May.
We’ve moved this dotted line up to five and a quarter is probably the most likely outcome. Then you get a pause that lasts through at least six months or so. The Fed is telling us that their intention is to be on hold through the rest of this year and into 2024. That’s what their forecast says. Most of the rest of the world does not agree with that. The really big question is when does that pivot start? If they’re really going to orchestrate a soft landing and a recession is maybe coming our way, does the pivot have to happen sooner than 2024? There’s a lot of arguments on both sides of that. Most of the world’s coming down on the side that the pivot, will start late in the 2023 and then we’ll have made a move.
Because that timeline has really moved around lately. It was out to 2024 a few months ago, then we had a banking terminal, as we suggest may help the Fed a little bit, then it moved back into 2023.
The wildcard has to be what happens with inflation, we just had a core print of 5.6 CPI. If you look at where we are on a real basis, we’re still at a negative interest rate on a real basis at Fed funds but if inflation starts to come in quickly, all of a sudden Fed Funds becomes positive on a real basis and then you get a very tight monetary policy as opposed to today, which is moderately loose. There is a lot of variability in that forecast and it can happen quicker than people are thinking.
Let’s say the Fed goes on hold right now or if they move one more time, we all believe inflation is probably coming down and that means rates are becoming more and more restricted even though the Fed isn’t doing anything and that sets them up for the ability to pivot later.
Let’s look at the OIS curve, it’s one of the forward-looking curves for Fed funds. You can see what the futures market was expecting from Fed Funds up above five and a half this year, and staying very high even as we get into the first quarter of next year. The futures market was telling us we’re going to be at five and a quarter going all the way into the second quarter of next year, we were really worried about infractions just three or four weeks ago, then that little banking turmoil thing hit and everyone’s forecast changed and you can see the dramatic drop to March 15th, which is just a week later. That’s how much it shifted in a drop by 200 basis points in one week, the expectation for what the Fed was likely to drop that much and so you had it peaking and actually a pretty dramatic easing happening later this year, right in the middle of all that turmoil.
Then things calmed down a little bit and started to move, the expectations start to move back up and then our friends in the Fed met on March 22nd. They kind of met in the middle and in green is what you see is the Fed Funds dot plot, their estimate is that they came up with when they just met in March. The Fed is still estimating they’re going to be going higher and staying higher. On the bottom, you see what happened to the Fed Funds futures expectations coming from the bond market after things settled down and that’s what we just talked about probably peaking at five, maybe a little higher but the bond market and the futures market are saying that they’re going to be easing as you get to the second half of 2023.
There’s a big disconnect between what the Fed is saying, and what the bond market is saying and that’s something we’re talking about internally all the time, there’s a very large disconnect there. Who’s going to be right? The Feds or the bond market.
Where is the Fed going?
When I look at treasuries, that should give me some idea where the Fed is, what they’re going to do, and where Fed funds should go. The 2-year Treasury stands at 4.2% this morning and the 10-year Treasury stands at 3.6%. That tells you where inflation expectations are and where rates are headed.
The bond market is not saying that the Fed is going to be on hold for a year or longer and easing very, very slowly, the bond market says that inflation is coming down and the Feds going to be moving pretty aggressively. It’s hard to bet against the bond market but there’s a big difference between the bond market and the Fed right now and what it does lead to.
There’s a five-year forward inflation expectations number the Fed likes to follow a lot and it really hasn’t moved very much. It spiked up a little bit last year when we were getting our first scare about inflation and it settled down and is right on top of that long-term Fed target. The inflation expectations futures market all along has said that inflation is going to come back down, kind of backing up what’s happening in the bond market right now.
Let’s move on and talk about our forecast for GDP. When you put all that data into the economic blender, what does it mean to our forecasts for economic activity GDP growth? What I show you here is quarter-by-quarter GDP growth going back to ’99. Again, the shaded vertical areas are periods of recession but on the right-hand side, you can see our forecast. What’s interesting is, remember that we’re coming off last quarter 2.6% GDP, we will have first quarter GDP here momentarily in the next couple of days but you can start to see that all of a sudden, we’ll see the slowdown towards the end of the year and that’s our bumpy landing that fits into our annual theme of prepare for landing, that more than likely, we won’t see a soft landing meeting avoiding a recession entirely.
Given all the research we walked through, we probably won’t see a severe recession either. It’ll probably be this bumpy, landing, mild and short live, skidding sometime in the second half of the year, and then the Fed pivots. Then we start the new economic cycle.
If you look at all the data that we just highlighted, you think that’d be bad for stocks, and one that we want to make clear is that we think a lot of the bad news that we just highlighted is priced into the stocks. Not all of that is priced into some of it, and that’s part of the decline of over -20% last year. Just to look and see what’s troubling to why stocks are rallying this year and one thing you look at is just confidence and sentiment and if you look at consumer confidence and sentiment, it’s extremely negative.
What we did here is this graph, consumer sentiment index, relative to 12 months falling returns and if you look at the colored circles we have here, those are the troughs in consumer sentiment in the following 12 month returns 1980 20%, 1990 29%, 2008 23%. The last seven periods when consumer sentiment hit a trough or negative extreme like we are now you had 25% returns, really bullish for stocks.
Typically, when there’s bad economic news out there, the investor sentiment is negative as you point out those troughs, but then all of a sudden, stocks valuations are attractive, and you get those nice returns 12 months later. We don’t want to suggest that we think the market is going to go up 25%, that’s not the takeaway, this helps explain why stocks are a big percent this year.
The next question is going to be about earnings. If we think we see this economic slowdown in the second half of the year, what does it mean to earnings because we know earnings eventually drive stock prices?
If you had variance data, an earnings slowdown definitely is in the works and it dovetails with economic message that we highlighted. Our forecast for 2023 earnings this year were to be flat, 0% was the forecast several months ago. 2023 consensus expectations are barely 1% EPS growth.
2022 was up nearly 4%. An earnings slowdown was happening and that rhymes with the economics slowdown.
Impacting stock action
We’ve been talking about a Fed pause perhaps soon, maybe after next month, and then even a pivot perhaps towards the end of the year and or early next year. What does that mean to stock action?
It’s incredibly bullish. If you look at when the Fed pauses or nearing the end of the Fed cycle like suggested within maybe one more move, the following 12 months, the average return for stocks is 18.9% over the last several cycles. The takeaway too on this data is this does not drive our investment process or philosophy. This is some of the data that we watch and monitor as the data is released.
We’re not really going to change our forecast because like we’ve mentioned over previous calls, every year on average you get a 14% decline. We haven’t had a decline this year, so we would expect it to be bumpy in the short run, and to possibly end the year 7-10% where our forecast is now.
As we think in terms of asset allocation, we’re always thinking about when we’re going to put risk on. Now we have our two buckets of risk assets and risk control. We’ve been going through the whole process about expanding our asset allocation. We have real assets, we have natural resource infrastructure, we have real estate as well. As we think about adding risk assets, there’s definitely this slowdown in earnings. Are you anticipating that we are at a point where we should start to add risk assets on from an asset allocation perspective?
We definitely think that we’re closer to adding risk on than not because like I mentioned previously, a lot of the bad news is priced in and even if earnings do decline, stocks can still go higher. Is the takeaway.
Our second bullet point on here is real estate, so if you think about– if unemployment really starts to spike, that’s going to put a lot of pressure on the ability for people to actually get housing loans. We’ve seen deposits flow out as well and so we will have some pressure on real estate assets. Also in the commercials space, we’ve seen contraction as companies are giving the keys back. There should be some pressure on real estate. Infrastructure is an area that we continue to see some opportunities for a few reasons we still need yield in the portfolio.
High-quality yield typically comes from real estate and then fixed-income opportunities. We see the short end of the curve giving nice strong yields two years sitting about 4.5% and the 10-year is less than 4%. We have that inverted curve as we think about that as well, we have this barbell approach to asset allocation where we can allocate capital for those that look at income and those that need growth in the portfolio.
With regard to the fixed income opportunities this setup is one that is ideal for opportunistic credit, particularly in private markets. Being able to have capital committed to managers who are dedicated to dealing with workouts and dealing with the issues that may come if we get as KC said, the most advertised recession on the planet. This idea is that there’s going to be a credit cycle at some point, and having money committed to those managers before that credit cycle really takes hold is one of the few times that you can opportunistically or tactically add to private markets because once the credit cycle has happened, it’s too late to try and get money in.
As we think about that, we always want to be mindful of the fact that the opportunity set for all investors not equally weighted. When we look at private credit, opportunistic credit, typically a qualified purchasers, qualified investor credit investors, as we look at some of our clients that are not in that qualified range, how do we think about allocated capital in the private, in the fixed income space so they can still get those nice attractive yields?
Once we see a correction or in the case of fixed income, once we see credit spreads start to widen we’ll have to try and play the timing game for those that are restricted to liquid assets.
One thing we haven’t talked about is dividends paying equities at all. We’ve talked about fixed income as an income source. We’ve talked about opportunistic credit, private credit, short end of the curve, long end of the curve but we also have this other source of income that sits out there. Are you seeing this as an area where we should start to think about dividend-paying equities as well as a conjunction to what we’re doing on the equity side?
There’s an opportunity because the dividend-paying sectors apply this year competing with fixed income. In our outlook, if the pause and then therefore a pivot happens in rates, rates come down, those dividend-paying sectors come back in favor and they’re more competitive yield offerings than. If you look at any historical study, over the long-haul, companies that are growing their dividend those are one of the best-performing parts of the market.
Dividends are real. They get paid out and they’re also a vote of confidence regarding earnings. Companies aren’t going to pay out a lot of dividends if they don’t have the earnings right behind that dividend. That’s why we keep an eye on many of our equity strategies. We’re keeping an eye on dividend and dividend growth because it speaks volumes to expected earnings growth.
Expected earnings for expected growth in general and expected expansion of the economy as well. In contraction, we typically see those dividends start to evaporate away as we start to grow those dividends become frothy and actually become more allocated across. That’s why I wanted to bring up this point around dividends. Again, because we have different areas in which we can allocate capital stocks, bonds, cash, and then within those stock, bonds, cash areas, we have private opportunistic credit, we have standard instruments as well.
On the equity side we have value growth and so most portfolios now are really growthy at this point, large growth center. We see some opportunity in small growth as well as a small cap has actually started performance well.
Here you can see our forecasts for this year. We have a reference point of what happened in the last three years, what we started the top line, here’s economic activity, inflation-adjusted real GDP. You can see the slowdown. Of course, a great growth in 2021 coming off the global recession. It’s a nice growth last year and I do think that we’ll still see a positive number even though you’ll see that slowdown in the second half.
Even though I believe the NBER, the official agency of dating recessions will say we experienced some type of recession starting in late 2023. I still think you can get a positive 1% GDP growth rate for the year. Unemployment– I do think that will start to go up. As we talked about it is not a leading indicator. It’s a coincident indicator and I think that will go up from the current 3.5% closer to 4 and that will give you an indication at that time that’s when the recession is actually starting, probably later in the year.
The official forecast for Fed Funds, is one more hike in May up to five and a quarter as we talk about long hold probably through most of the year. We are estimating again we’ll be back in easing mode in the fourth quarter of this year. We have on here back down to 5% and on their way lower as we go into 2024.
For the 10-year treasury, we’re a little range bound. We’ve covered a lot of territory already since the end of 2022. What’s important on here, we have it at 3.5 just a little lower than where it is now. We think the 10-year has reflected most of the news that’s going to come out. It moved early and it’s moved hard. It could be extremely choppy between now and the end of the year, but we think 3.5 is probably the best guess for it for the end of this year. The whole thing if we’re right about going into 2024, that would be all rates moving lower as we go into 2024.
Then lastly, here’s our forecast for the S&P 500. At the end of the year and we haven’t changed it, we think somewhere between 7-10% probably going to be a little choppy. Here we are up 8.5%.
A correction could happen and it doesn’t have to be a specific event that causes it. It could just be a mean reversion historical mark go through cycles and mean revert, and that’s what we expect this year.
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