By Ellen Hazen, CFA®, Chief Market Strategist

November 30, 2022

November Takeaways:

• Inflation continues to ease, with the October report below September’s report
• Unemployment remains low by historical standards
• Both October and November jobs data came in stronger than expected
• Economists continue to reduce GDP expectations
• The Federal Reserve increased the Federal Funds Rate by an additional 0.75% in November
• S&P500 companies reported Q3 earnings that continued to exhibit negative operating leverage
• Both equity and fixed income asset classes continued their sharp rally from the October lows

What We Are Watching In December:

• S&P500 earnings estimates for 2023 have declined by 8% since June, but still imply 4% growth over 2022. We expect 2023 estimates to continue to decline, and expect earnings could be merely flat in 2023
• The Fed will meet on December 14 and 15 and is widely expected to increase the Fed Funds rate by an additional 50 basis points, to 4.5%
• The Consumer Price Index (CPI) will be reported on December 13. The market is currently expecting 7.3%, a further reduction from 7.7% reported in October and down from the peak of 9.1% in June
• The Federal Reserve Bank of Atlanta’s Atlanta GDPNow forecast is currently calling for 2.8% GDP growth for Q4 2022

We expect continued volatility in both equity and fixed income asset classes as the market assesses conflicting signals with respect to the likely trajectory of economic growth and earnings growth in 2023 and beyond.

Over the past year, valuations in both equity and fixed income markets have significantly compressed, making these markets more attractive than they had been in some time, although still not cheap. The S&P500 is currently trading at just over 17 times 2023 earnings estimates, modestly above its long-term averages. At a 3.5% yield, an investor earns more today investing in a 10-year Treasury bond than at any time since 2011 (except earlier this year when yields briefly touched 4.3%). We recommend using the expected volatility to buy selectively.

Are We In A Recession?

Many clients are asking whether the US is in a recession, or will enter one in 2023, and if so, what that means for their portfolios.

Market observers’ forecasts for US GDP growth in 2023 are widely divergent. Of the 60 economists submitting forecasts to Bloomberg, the range is unusually wide, from a low of -1.1% to a high of +2.9%. The median estimate of 0.4% would represent a further deceleration from 5.9% in 2021 and 1.8% (estimated) in 2022, and the slowest growth since the pandemic, and before that, the global financial crisis (GFC) of 2007-2008.

When 60 leading economists were surveyed several weeks ago by the Wall Street Journal about the probability of a recession within the next 12 months, the responses ranged from a 20% probability to a 100% probability, with the median economist predicting a 65% probability of recession within the next 12 months. Clearly, today’s tea leaves are not easy to read.

How Is Recession Defined?

The National Bureau of Economic Research is the formal arbiter of recessions. The NBER’s definition emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months. In other words, it is not merely the commonly discussed two consecutive quarters of Gross Domestic Product (GDP) decline, but must also be spread across the economy and it must be significant. The NBER has historically evaluated a wide range of economic data, including, crucially, labor market health measures.

We can see in the chart below that over the past forty years, a formally defined recession (as indicated by the red shaded vertical bars) has always occurred during a time of rising unemployment. The current labor market strength is one of the principal reasons that we believe a recession, if one occurs, will likely be shallow. We have discussed at length in client meetings how the current low labor force participation rate is leading to a continued low unemployment rate and thus to robust household finances. (Although household finances would be stronger if wages were keeping up with inflation).

Other Historically Relevant Indicators

While we watch numerous economic and market indicators, three other measures on which we focus are worth considering at the moment. These are the US Conference Board Leading Economic Index, the slope of the yield curve, and credit spreads. Each is displayed in the following charts.

Both the Leading Economic Index and the yield curve have slipped into negative territory in recent months. An LEI below zero is typically, although not always, followed by a recession. We can see that in the mid-1990s and again in the mid-2010s, a negative LEI reading was not followed by recession, but most other negative readings have been followed by recessions. The timing from the negative LEI reading to the onset of recession, if one occurred, ranged from only two months to 17 months.

Similarly, a negative 10-year minus 2-year Treasury curve is also generally, although not always, followed by a recession within the following twelve to eighteen months. Again, though, this is not a foolproof predictor: neither of the negative 2-10 curves observed in 1998 or 2006 were followed by recessions.

Moreover, credit spreads are telling a fairly sanguine story. The spread between BBB-rated corporate (i.e., investment grade) 10-year yields and 10-year Treasury yields is not at levels historically predicting a recession. The current spread of 2.34% is barely above the long-term median of 2.21%. The corporate bond market does not seem to be overly concerned that a recession is imminent. This is true whether we examine investment-grade debt or high-yield debt.

Thus, historical guideposts are not particularly illuminating when assessing whether there will be a recession in 2023. The strong labor market may offset traditional indicators, and not all traditional indicators are flashing red at this point. We are fairly confident that earnings will slow, and that GDP will slow, but given the unusual health of the labor market, we conclude that indicators that predicted prior recessions may be largely unreliable this time.

Markets Are Forward-Looking

According to Ned Davis Research, the S&P500 declines by an average of 3.8% from the start of a recession until six months later, then rebounds, so that twelve months after the start of a recession, it is an average of 1.6% higher than pre-recession levels. The sharpest declines occur between two and three months after the onset of a recession, and the S&P500 bottoms an average of four months before the recession ends.

Putting it all together, we believe that with some indicators flashing yellow, while others look healthy, any recession is likely to be mild.  The bottom line is whether there is a formal recession or not, our near-term investing approach is the same. In both a recession and a non-recessionary slow-growth economy, we prefer to own quality, cash flow generating equities and high credit quality bonds. When there is visibility to economic reacceleration – and that visibility will come at some point – that preference will shift to more economically sensitive areas of the market.

Disclosures