Investors often love to make predictions. And sometimes those predictions become reality. But as the saying goes…there are only two kinds of forecasts: the lucky and the wrong
Take 2019-2020, for example. Growth had begun to slow late in 2019 after a decade-long expansion. Then came COVID. Most may have assumed a global pandemic with economic shutdowns would have decimated the markets. And while it did initially, fast-forward to year-end 2020, and the S&P 500 Index returned 18.4%.1
Then look at the predictions going into 2021—the chart below shows how they missed the mark…by a wide margin in many cases. These examples are not unusual because forecasts are often wrong—whether it’s the direction, magnitude, or impact.
Source: FactSet, U.S. Bureau of Labor Statistics and AllianceBernstein*For GDP, actual 2021 refers to the estimated 2021 outcome of consensus forecasts as of December 2021.Past performance and current analysis do not guarantee future results. As of December 31, 2021. Based on consensus forecasts as of December 31, 2020. S&P forecasts are based on the average analyst target prices, generally for the next 6-12 months. U.S. inflation is based on seasonally adjusted year-on-year figures, and the actual 2021 outcome is based on the November consumer price index reading.
Despite the lack of reliability of prognostications, your clients probably watch the news and see various forecasts and projections touted as gospel. Perhaps they’re asking you about reallocating their assets away from stocks, how long this inflationary period will last, and whether their financial plan will crumble during a recession.
You might not have the perfect answers. And we’re here to tell you, no one does! But that’s not to say we should walk aimlessly into the future and ignore the impacts of many possible investing environments. Armed with insights on three key themes—sustained inflationary pressures, rising interest rates, and fears about a recession—we hope you can better address your clients’ concerns and feel more confident as you manage portfolios in a volatile environment.
When we consider macro forces that may impact our portfolios, we ask ourselves several questions that can help us understand the underlying dynamics of a business. Some may include:
- Is it a sustained shift or short-term noise? For instance, do we believe remote work is a permanent shift in business operations, or a short-term solution to COVID-19?
- Will it permanently change competitive dynamics? Illustrations of this are e-commerce taking sales away from brick-and-mortar retail, and regulations that broke up telecom monopolies.
- Is it a page, chapter, or new book in the future of the company? For example, does the rise of streaming services cause a new page, chapter, or whole new book for traditional media?
- Does this change the geographic power structure? In other words, do certain countries benefit or lose out? How can the logistics supply chain cope with this?
- What’s the new equilibrium? Meaning, if wages rise, does that lead to lower corporate profit margins, higher end-user costs, a reduction in spending elsewhere, or some combination?
As we answered these questions recently, we identified three themes that we believe may influence the stock market over the next 12-18 months: sustained inflationary pressures, rising interest rates, and concern over a recession.
What’s interesting about these themes is that they’re interconnected—one can lead to the other!
Now in this discussion, you’ll read about things like “real” and “nominal.” So before we get started, let’s break down some of the inside baseball speak!
“Nominal” means a literal amount. For example, I made $100 in 2020. My mom made $100 in 1980. The nominal amounts are both $100. But are those $100 worth the same? No, because of inflation. So “real” takes the nominal and adjusts it for inflation.
Think of real as the actual worth to make the comparison fair. The chart below shows how our “real” purchasing power over time has declined.
Source: St. Louis Federal Reserve. Data through Nov. 2022
Why Does Inflation Matter?
What is inflation?
Ask anyone who lived through the 1970s and early 1980s, and they’ll tell you all about inflation. Long gas lines. Skyrocketing meat prices. “Whip Inflation Now” buttons. The loss of purchasing power as prices went through the roof significantly hurt many households, making those years the poster child for out-of-control rising prices.
This period resonates today because inflation hit highs in 2022 we haven’t seen since then. Surging labor, raw material, and energy costs have everyone paying more for food, gasoline, and housing, to name a few expenses hitting the pocketbook hard. While paying more for raw materials and energy hurts, increased wages sound like a good thing—because people get paid more.
So should we always be concerned about inflation? It depends—on both the type of inflation and what sets it in motion.
It’s kind of like the Three Bears nursery rhyme: If the economy is too hot, inflation can get too high, and that’s bad. And if the economy is running cold with too low or even disinflation, it is also bad. But, somewhere in the middle—roughly identified around 2% by the U.S. Federal Reserve (the Fed)—seems to be just right. It’s in this middle ground where markets are in equilibrium, and suppliers and consumers have maxed out their utility—meaning they’ve reached their highest level of satisfaction.
How is it measured?
The Consumer Price Index (CPI) measures the average change over time in the prices paid for a market basket of goods and services.2 It assesses everyday expenses such as food, housing, apparel, transportation, medical, recreation, and education. Inflation is the rate of change of the CPI.
However, sometimes looking at the total market basket distorts the actual level of prices, especially if one category is a bit wackier than the others. So instead, some people prefer using core inflation. Core inflation is the basket of goods and services excluding food and energy. The reason for their exclusion? Energy and food are typically more volatile than other categories, so they may unduly make inflation appear better or worse. The graph below shows this tendency—as the dark orange line has less extreme ups and downs than the lighter yellow line.
Source: Bureau of Labor Statistics. Federal Reserve of Atlanta. Data through Sep. 2022
Is wage inflation a negative?
As we mentioned earlier, wage inflation is a growing concern. One reason behind the uptick in pay is the accelerated retirement of many workers since the pandemic. For instance, COVID created roughly 2.4 million early retirees above the usual trend, about 2% of the workforce.3 As a result, there is a shortage of available employees, especially in some key industries. So, to entice workers, companies have offered more pay—about 5.0% more over the last 12 months—thus causing wage inflation. But is paying workers more a bad thing? Unfortunately, at some level, it is harmful to the economy. Here’s why...
Average U.S. wages have risen steeply since 2020, as you can see from the chart below, which shows the year-over-year percent change in U.S. wages, salaries, and benefits from 2018 through September 2022. When wages go up, businesses typically must charge more for their products and services to cover the cost of paying their employees more. At the same time, increased pay gives consumers more money to spend. So, their demand for goods and services surges, typically forcing prices higher. As a result, prices go up on both fronts, ultimately reducing consumers’ purchasing power.
Source: U.S. Bureau of Labor Statistics. The chart shows the year over year percent change in wages, salaries and benefits
through Sep. 30, 2022. Data is 12-month percent change, not seasonally adjusted, for civilian workers.
What to watch out for?
Many economists believe today’s inflation results from supply disruptions and bottlenecks and the drastic increase in money supply, primarily from government stimulus during the pandemic. The war in Ukraine is also causing global price increases in some key categories, like natural gas, oil, wheat, and corn. Wage growth has been another driver.
The chart shows the sharp increase of money in circulation since the beginning of the pandemic. Notice the significant uptick relative to the response to the 2008 Global Financial Crisis.
Why do we care about money supply? Because the price of goods and services is a function of the money supply, and the rate at which spending accelerates. Let us unpack this economic mumbo-jumbo!
If the amount of money in circulation (money supply) increases, and/or consumers would like to spend more (think: increase the frequency of exchanging money) but there aren’t enough goods or services available for purchase, prices go up.
Let’s walk through a hypothetical example: Cecilia and Derrick are looking to buy a new house. They saved over the pandemic–by not commuting and working from home, not eating at restaurants, and not spending some of stimulus payments from the government—for a down payment. But as they begin their search, they realize two things: First, there aren’t that many houses up for sale. Second, many other buyers have similar savings and are in the market. Unfortunately, they end up in a bidding war as several other buyers vie for the same house. The outcome: The winning bidder paid more than 10% over the asking price.
So, an increase in money could mean there are more dollars chasing the same number of goods—homes in this instance. This increased demand without an increase in supply pushed up prices.
When inflation first spiked in the summer of 2021, the Fed labeled it as transitory and largely perpetuated by supply bottlenecks from the pandemic. Now we know that inflation is more sustained.4
Not only are supply disruptions continuing, but also the war in Ukraine is putting pressure on many commodities because of import and export restrictions and production disruptions. At the same time the U.S. job market remains strong. The Fed has aggressively raised rates to halt inflation and is expected to drive the Federal Funds Rate higher from where it ended 2022, which was 4.25%-4.50%.5
The market expects that these moves in addition to supply abatements could result in inflation falling to 3.5% in 2023 and 2.1% in 2024.6
Source: Board of Governors of the Federal Reserve System (US). Data through Nov. 2022
How could it impact your portfolio?
Investing during inflationary periods may sound daunting. It’s especially concerning for individuals living off a fixed budget—like many in retirement—because significantly higher prices may erode purchasing power faster than anticipated.
So, the first consideration when investing is determining which asset class holds up best during rising prices. Over the long term—inflationary periods included—investors holding corporate or government bonds have fared worse than those holding stocks. For example, from 1970 through 2020, the S&P 500 delivered an average annualized real return of 7.9%. That compares to a 4.5% return for corporate bonds and 3.3% for 10-year Treasuries.7
Stocks beating bonds over the past 50 years is not surprising. But what’s remarkable is that stocks also delivered robust real performance even during periods of moderate inflation. For example, 50 years of research show global and U.S. stocks posted double-digit returns during periods when inflation was 2%-5% (See table below).8
What about holding cash? The value of money decreases over time as inflation takes hold. That is because a dollar today can buy more than a dollar tomorrow if prices rise. So like bonds, holding cash may not be beneficial during inflationary spikes.
Source: Datastream, Federal Reserve Bank of New York, AllianceBernstein. Past performance and current analysis do not guarantee future results. As of May 31, 2021. The table shows average year-on-year returns for different equity indices in different inflation regimes. Inflation regimes are proxied by the U.S. 10-year TIPS implied breakeven inflation rate. Pre-1997, the 10-year breakeven rate is a backcast of implied inflation calculated by Jan Groen and Menno Middledorp from the Federal Reserve Bank of New York. U.S. CPI index is used to convert nominal to real returns. Global based on MSCI World. U.S. based on Global Financial Data U.S. Index and the S&P 500.
Why do rising interest rates matter?
What is the Fed?
The Federal Reserve (The Fed) is the U.S. central bank—the government agency responsible for monetary policy in the U.S. It has several main purposes. Two primary ones are:
- To set U.S. monetary policy to promote maximum employment and stable prices in the U.S. economy.
- To monitor financial system risks to help ensure the system supports a healthy economy for U.S. households, communities, and businesses.
One of the levers the Fed uses to support a healthy economy is to raise or lower the federal funds target rate, which influences the rate given to borrowers, or the interest earned in a savings account.
The chart below shows both the target and effective rate since July 2000. Before last year, there were only two periods of restrictive monetary policy when rates were hiked—mid-2004 through the end of 2006 and December 2016 through 2018.
2022 started with the rate at effectively zero, which is where it’s been since the pandemic started, and frankly, for most of the decade since 2008’s Global Financial Crisis. Extremely low (effectively zero) rates encourage businesses and consumers to spend to spur economic growth. Sometimes that spending can be too high and “overheat” the economy—meaning prices rise at a fast pace. So to slow it down, the Fed may hike rates.
Source: Federal Reserve Bank of New York. Data from July 3, 2000 through Dec. 9, 2022
What’s the impact of higher rates on inflation?
When the Fed increases rates, it says: Slow down and take a breath. It wants consumers to stop spending and save. It’s like applying the brakes when you go 100 miles per hour into a curve. Braking is the smart, safe, and best option if your goal is to keep driving and not crash.
Let’s look at an example:
We examined two scenarios with different interest rate environments (display below). In scenario 1, interest rates are 1%. In other words, banks will pay you 1% to keep your money in a savings account. However, most people may not think receiving 1% is worth keeping their money in the bank. Instead, they’d rather spend it—on new cars by getting cheap auto loans or new homes using low-rate mortgages, or simply buying everyday goods and services. This spending can lead to higher inflation as demand surpasses supply.
In scenario 2, the Fed hiked rates from 1% to 4%. Now banks will pay you 4% to keep your money in a savings account—a decent return and a safe way to hold your cash. More importantly, getting loans for new cars or homes is significantly more expensive than before. That can make a big difference in the way consumers view spending. So instead of driving up prices with unstoppable demand, higher rates can attract more savings and less spending, thus leading to lower inflation.
The takeaway? By making money more expensive to borrow, the Fed effectively removes some excess capital from the market. And because too much money chasing too few goods is the classic definition of inflation, taking money out of the market slows the cycle of price increases.
What to watch out for?
At its December 2022 meeting, the FOMC raised its rate for the seventh straight meeting, a hiking schedule it hasn’t maintained since 2005. And the market expects more at this point, albeit at a slower pace. A higher for longer range is expected as the Fed fights inflation.+ Rates at the end of 2022 fell in the range of 4.25%-4.50%, and the Atlanta Fed expects rates at the end of 2023 to be around 4.30%, then falling to 3.20% by the end of 2024.**
In concert with rising interest rates, recession fears are also climbing. A recent poll of economists puts the odds of a recession by the end of 2023 at 70%, up from 33% at the end of the first quarter 2022.* These odds signal that most economists don’t believe the Fed can strangle demand without spiraling the economy into a recession, the soft-landing scenario many had hoped for.
How could it impact your portfolio?
Higher rates can affect both stocks and bonds.
Stocks: Elevated rates can hurt companies in two ways. First, businesses that rely on debt to fuel growth may face less profitable growth. As borrowing becomes more costly, profits suffer. Unfortunately, many companies have come to depend on cheap debt from banks and venture/private capital firms over the past decade.
But when the market turns down, companies can’t simply re-extend their credit. They have to pay it off to have a profitable business. To quote Warren Buffett, “When the tide goes out, we see who has been swimming naked.” Those naked swimmers tend to be unsustainable companies that rely on external funding to operate. Another unfortunate outgrowth of the cheap money growth strategy is how long it’s lasted—for over a decade. This is a problem, because many of the individuals in upper management that last dealt with a rising rate environment are now retired.
Second, discount rates, which are tied to interest rates and go into stock market valuations, will be higher. That hurts high-growth companies that tend to have a more significant proportion of their earnings in the future. Why? Because the further out into the future that profits occur, the more they are discounted, reducing a company’s valuation. Therefore, companies that have more out-year versus current-year profits will decline in value as interest rates—and thus discount rates—rise.9
Bonds: The impact of rates on bonds is more straightforward. Most bonds offer a fixed coupon–a regular payment to the bondholder. But when rates are higher than the coupon, investors could make more money buying a newly issued bond with a higher coupon. Therefore, the old bond’s price falls to attract more buyers. When that happens, holders of the bonds lose value.
Why does a recession matter?
What is a recession?
A recession is two or more quarters of a slowdown in real gross domestic product (GDP). Notice we said “real.” That’s so rising prices—inflation—don’t influence whether a slowdown happens.
Recessions are characterized by higher unemployment, lower incomes, a slowdown in industrial production and manufacturing, and a slump in consumer spending. Moreover, they impact large and small businesses as credit tightens and demand slows. The result? Fear and uncertainty, which dampen consumer sentiment. Because even in economics, it matters how people feel!
Could a lack of recession this year surprise the market?
A recession is inevitable at some point. That’s because it’s a natural part of the economic cycle. As the graphic shows, the business cycle moves from an expansion to a peak, then through a recession to a trough, before it recovers and starts anew.
Two questions usually accompany the recession discussion: When will it happen? And, how deep will it be? The answers are educated guesses based on market indicators and signals.
But since we are not economists or in the business of forecasting the economy, we’ll make this bold statement—we expect a recession…at some point. Helpful? Probably not. At the beginning of 2022, the more apropos question was could a recession hit sooner than investors anticipate. But as we start 2023, investors are asking whether or not we’re already in one?
As we mentioned, the odds of a recession in 2023 have risen to over 70%, as the Fed is trying to lower inflationary pressures by cooling economic demand. As we discussed earlier, one of those pressures comes from the labor force.
If a recession does occur, how long could it last? Unfortunately no one knows. The issue lies in how the economy responds to the rate hikes and if the Fed goes too far. For example if the Fed maintains a higher interest rate range and effectively chokes off demand such that unemployment rises greater than the targeted amount, then a recession may be more prolonged than if it chokes off demand just enough to hit its unemployment goal.
Going back to the 1980s can put things in perspective. The U.S. entered a recession in the early 1980s after the Fed raised rates to fight inflation. This was an intentional action given the Fed’s dual mandate of controlling inflation and employment levels. In fact, their job has often been referred to as taking the punch bowl away before the party gets out of hand!
So, it’s not the Fed’s job to prevent recessions.
But it is debatable whether the modern Fed has the willpower to ignite a recession to achieve its mandates. During the dotcom and housing bubbles, their resolve was low, as many believe they acted too slowly. So, will this time be different?
Recent headlines have mentioned that the Fed is more “hawkish,” with an accelerated timeline for tapering bond purchase and hiking rates. (The Fed is often described in bird-terms—with a hawkish view being more aggressive and predatory, while a dovish stance is calm and laid back!) While the short-term rate will be higher, it is anticipated the FOMC will maintain a fed funds rate between 3.75% and 4.00% over the longer term. The reason for the increase is to achieve maximum employment and 2% inflation over the longer run.
What to watch out for?
Many investors watch the shape of the yield curve as a warning sign of an impending recession. But not just any shaped curve…it’s an inverted curve.
A normal curve is upward sloping. This gives bonds with maturities that are many years into the future higher yields because they are deemed riskier since the future is less certain than the near term. But an inverted curve is downward sloping. This inversion means investors are demanding a higher yield for short-duration Treasury bonds. In other words, they think it’s riskier to hold bonds over the shorter term. For example, with an inverted curve a 2-year bond may have a higher yield than a 10-year Treasury.
An inverted yield curve is one of the only indicators that is not backward-looking and has preceded recessions for the past 50 years. But while every recession was preceded by an inversion, not every inversion leads to a recession. And if it does, the inversion itself doesn't predict when a recession may occur or how long it'll last.
In addition, we tend to look at other signs to understand the likelihood of a contraction:
Overall spending and consumption levels. Currently, they remain high. Although accumulated savings remain high, they are dwindling. Consumer sentiment is also low.
Business investment. As one of the major drivers of GDP growth, this could be a problem. Business sentiment is also falling.
Technical indicators. Credit defaults, high unemployment rates, and a decline in housing prices are a few other data points to watch. They may be turning, indicating a slowdown.
Source: Corporate Finance Institute. This graphic shows the hypothetical shape of a normal and inverted yield curve for illustrative purposes only. Accessed Nov. 10, 2022
How could it impact your portfolio?
Any slowdown in economic activity can hurt company profits. But just like most things in life, not every business will be affected equally. As we said earlier, companies that rely on debt to grow probably don’t have sustainable businesses. And companies that lack customer loyalty or deliver products and services that are considered luxuries may experience a more significant downturn than those that provide necessities. The types of businesses that can typically raise prices during inflationary periods are generally able to weather the storm more successfully.
Inflation + Interest Rates + Recession
At the beginning of this report, we mentioned that inflation, interest rates, and recessions are interconnected. This is how:
Higher inflation means consumers are losing purchasing power—their money doesn’t go as far, which diminishes their confidence. This loss of confidence often results in spending less and saving more, reducing demand. Lower demand forces companies to increase layoffs and decrease business investment. These actions can lead to a recession.
Typically, the lower demand reduces inflation. Cheaper prices lead to higher purchasing power and often more confidence. This increased confidence means consumers spend more and save less, increasing demand. Higher demand forces companies to hire more workers and make more business investments. This can lead to an expansion.
As demand increases, prices may rise, and the cycle starts anew.
Fortunately, not all inflationary periods lead to a recession. And if they do, not all recessions are the same—some are short-lived while others persist for years. For example, we talked about the global oil price shocks that caused high inflation in the mid-1970s. These shocks led to increased production costs. At the same time, there was high unemployment. Together, they caused an economic contraction and a recession. Nevertheless, inflation persisted despite the recession, further harming many households (a classic stagflation period—rising inflation during a recession).
The only way the U.S. got out of more than 15 years of high inflation starting in the 1960s was by the Fed raising interest rates as high as 20%, which eventually reduced demand for goods and services.
Managing for the Long and Short Term
Earlier, we discussed that many stocks generally do well during inflationary periods.
But which stocks? Some companies can combat the effects of rising input costs by passing them along to consumers; they have pricing power. So, after the initial shock of inflation, these companies can often overcome the impact on their earnings. One of those higher input costs today is wages. But we think some companies can still deliver large profits and shareholder value while raising
First, because it’s not a light switch. Profits won’t be eliminated if a large firm starts paying people $15 an hour, even if it takes several quarters to pass higher input costs to consumers. Eventually, consumers become acclimated to the new pricing environment and resume regular spending habits. These consumers become less likely to hold cash because its value over time—the purchasing power—decreases with inflation.
Second, because paying people more can increase productivity. Known as efficiency wages in economics, research suggests that if you pay people to do the job and they’re happy and healthy at work, they will be more productive.10 There will be more efficiencies, so it might mean attracting and retaining better employees, motivating existing employees as higher wages make a job more desirable, resulting in lower turnover. There’s a notion of working harder out of fear of losing a better-paying job and an innate sense of reciprocity. However, not every company will absorb and pass along costs. But we believe that quality companies can. By quality, we mean companies that:
Can raise prices
Generate positive cash flow
Have customer loyalty
Maintain competitive advantages
Do not rely on external sources to fuel growth
Rather than investing in quality, some investors bucket companies into growth or value. By doing so, they invest based on low market multiples (value) or growth expectations.
Instead, we look for companies that control their destinies and deliver returns to shareholders. Historically, these companies typically perform relatively well in all economic environments.
As the graph below shows, an index based on quality factors delivered positive returns in all inflationary scenarios (each color represents a real rate range) for 40 years beginning in 1980 until the end of 2019. In contrast, an index based on value factors delivered negative active returns in low-inflation (<0%) environments. In addition, it underperformed (relative to quality and momentum) in higher-rate (>3%) scenarios during the same period.11
Source: MSCI.com. Past performance does not guarantee future results. All factor indexes are for the MSCI World Index universe. Data for inflation is the annual inflation rates for advanced economies published by the International Monetary Fund. Real rate is defined as the forward-looking 1-year U.S. Treasury rate minus inflation. The three real-rate bins have almost the same number of data points. Time period for analysis is from Dec. 31, 1979 ro Dec. 31, 2019.
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