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ACM Journal - Investment Management
10 Oct

What if we don’t have a recession? – Q3 2023 Newsletter

Early last year, it was common knowledge that we were about to enter a recession. In fact, many in the media were calling it the most anticipated recession ever. Despite the certainty, we’re still in an economic expansion, and now many prominent economists, including those in the Fed and Treasury, are saying a recession is no longer in the cards.

That certainly sounds like good news, particularly when you consider that past recessions have generally been accompanied by stock market downturns. However, we’re not so sure we’re out of the woods.

First, we think there will still probably be a recession, or at least a long period of economic stagnation. The huge increase in government debt globally over the past few years all but guarantees that GDP will not be able to grow as it has in the past. There are other headwinds too with high interest rates, still uncontrolled inflation, and longer-term demographic problems, to say nothing of all the political and geopolitical strife we are now experiencing.

However, let’s say that we’re wrong and that Jerome Powell and Janet Yellen are correct. The economy will continue to grow, inflation will be brought in check, and we’ll all live happily ever after, right? Maybe not so much. We think that a mild recession is what the market is expecting currently and may be the best-case scenario for investors. If there is no recession, things could get ugly in the stock market.

The reason, primarily, is interest rates. Most days when weak economic data comes out, the stock market rallies in the hope that the Fed will stop raising short-term interest rates and may even cut them next year. However, strong economic data generally results in stocks retreating. Clearly the Fed and its impact on interest rates is having an outsized influence on stocks.

If we don’t have a recession, then the Fed is unlikely to cut short-term rates. That’s bad news for stocks, but we believe it is far worse than that. Currently the yield curve is inverted, meaning longer-term bonds yield less than short-term bonds. That usually only happens just before recessions. If it becomes clear that the economy will keep chugging along, it is likely that the yield curve will normalize.

That means that the ten-year Treasury yield will have to rise. The Fed won’t cut rates in a strong economy, and the Fed Funds rate is currently targeted at 5.25% to 5.5%. Historically the spread between the ten-year Treasury yield and the Fed Funds rate has been more than 1%. That implies the ten-year Treasury yield would have to rise from 4.6% at the end of the third quarter to something closer to 7%, particularly if the Fed continues to raise interest rates this year as it is signaling.

Can the economy handle long-term rates at 7%? That would probably put mortgage rates close to 10%, raise the cost of financing operations for corporations significantly, and consume far more of the government’s budget just for interest expense on its debt. People would not be able to pay as much for cars, and debt across all categories would become more expensive. That would slow consumer spending and reduce capital expenditures for corporations, restraining potential GDP growth.

High interest rates also impact the way investors value stocks. Lower rates equate to higher valuations and higher rates generally compress stock valuation multiples, such as the Price/Earnings ratio. It is unlikely that the tech sector would be able to sustain its lofty Price/Earnings ratio, and that would impact the pricing of the S&P 500, which currently has a lot of exposure to the largest technology stocks.

All of this suggests that a Fed-engineered soft landing or “no landing” scenario could be close to the worst-case scenario. But don’t worry, we’ll likely have a recession. That might not be great for stocks, but slow growth is probably less damaging than a big, unexpected spike in interest rates.

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