Head I Win, Tails You Lose
I remember arguing with my folks about having to do chores when I was a child. In one instance my father cut a deal with me where he would flip a coin with the outcome determining whether or not I had to do the chores I was arguing about. He told me if it came up heads he won but if it was tails I would lose. My naivety at a relatively young age coupled with my insistence on a quick win deterred me from stopping to think about what was being proposed. Obviously this was a guaranteed winning situation for my father and a losing situation for me. It is very possible we are facing a similar situation with the economy today – one where there seem to be two possible outcomes, neither of which are desirable.
Last week the stock markets performed strongly with the S&P 500 moving higher by more than 6%. This was a welcomed respite in what had been a rather brutal month in the market, especially after the sharp losses of the prior week. Absent any major catalysts for this move, it may be that after three weeks of negative markets there might have been some selling “exhaustion,” and investors decided it was a good time to buy. The S&P 500 is now out of bear market territory but still sharply lower year-to-date. Time will tell if this ends up being a bear market rally and we see other moves lower or if we did experience the bottom and this is the beginning of a sustained rebound.
There are indications corporate executives are viewing the recent negative sentiment in the stock market with caution and may alter expansion and hiring plans, helping to reduce inflation. If this results in lower inflation, there becomes the possibility the Federal Reserve may not raise interest rates as much as currently expected and perhaps even start to lower rates during the later part of 2023. This would be a major turn of events compared to two weeks ago when it was feared the Fed would need to raise rates aggressively over the next couple of years. This fear sent markets reeling two weeks ago after the Fed raised rates 75 basis points for the first time in 28 years. Lending credence to this theory was the notable drop in bond yields, including the 10-year U.S. Treasury pulling back from its multi-year high near 3.5% all the way down to near 3.0%. This may not sound like much, but it is a rather dramatic move for fixed income markets, which tend to be a stronger indicator of the future than the stock market.
But if the Fed does not need to raise interest rates as much as currently anticipated, doesn’t that mean we can avoid a recession and everything will be good? Not exactly – corporations cutting back on hiring or expansion could push the economy into a recession on its own. The silver lining being the Fed does not need to raise rates as much as thought during this cycle. However, if this does not occur and corporations continue to spend money and expand, which we hope they do, then the Fed will most likely find themselves in a situation where they will be forced to continue to raise interest rates aggressively, which also has a high probability of causing a recession. Hence, why this appears to be a “heads I win, tails you lose” situation in which there is not a desirable outcome.
The fact we will face a recession seems to be the consensus amongst many economists and market analysts with the question really being “when,” this year or next (or possibly 2024), and not “if.” The stock market reaching bear market territory, commodity prices falling, and the bond yield curve inverting all seem to be signs that a recession is imminent. But this reminds us of a quip from economist Paul Samuelson back in the 1960s, where he stated, “The stock market has predicted nine of the past five recessions;” meaning the stock market often gives false signals.
To consider an alternate outcome and play a game of “what-if” – what if the market has already priced in the worst scenarios? What if energy prices continue to drop? What if we somehow avoid a recession? What if inflation does quickly abate? What if the Fed does not need to raise interest rates substantially from here? What if corporate earnings continue to grow? A few weeks ago these scenarios individually may not have seemed plausible but now there is a growing inkling of hope they all could be. Energy prices dropped last week due to expectations for weaker demand going forward. This is turn will have a major impact on reported, and actual, inflation. We are not saying this is what will occur, but merely stating possible scenarios. If this were to occur we would expect a very positive reaction in the stock market, which could happen quickly and overly cautious investors might find themselves missing out.
We are faced with the prospects of an economic slowdown or recession, caused either by market forces or aggressive action from the Federal Reserve. The Fed no doubt is still trying to engineer a “soft landing” and avoid a recession but this is likely to be outside their control. Fed action may have little impact on some of the larger factors contributing to inflation, such as energy prices and continued supply chain issues. The “what if” scenarios given above would be the very best outcomes but they also may be the least likely at this point. Hopefully those odds improve in coming weeks.
This week marks the end of the month and end of the quarter so there is the potential for added volatility, especially early in the week, but given what we’ve experienced this year may not be too much out of the ordinary. The end of the week will most likely be quiet as we coast into the holiday weekend. When it comes to having a solid income and investment plan, be sure to position yourself with the best chances of winning and not find yourself facing a no-win situation. We are here to help you increase your odds of success.
Have a great week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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