First Quarter 2023 – Recession Still LikelySubmitted by Alsworth Capital Management, LLC on May 15th, 2023
The failure of Silicon Valley Bank (SVB) was the dominant story during the last quarter. Several other relatively small banks showed signs of distress, which shook markets. The Federal Reserve (Fed) stepped up and injected significant amounts of cash into the banking system to help counter any “run on the bank” contagion. It was a successful maneuver. Markets reacted positively to the action and the general consensus is that the Fed is also getting close to the end of it’s campaign of raising interest rates to cool down the economy. Virtually every sector of the market ended the quarter with positive returns. The S&P 500 index of large U.S. stocks gained 7.5% in the first quarter. Developed international stocks (MSCI EAFE Index) did a bit better, rising 8.5% for the quarter. Emerging markets stocks (MSCI EM Index) gained 4% for the quarter. Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index) returned 3% and gold gained 8% for the quarter.
Investment Outlook and Portfolio Positioning
With above-normal inflation and the Fed sharply tightening, the short-term outlook for economic growth was already poor coming into the year. Add to that the negative impact from tighter credit conditions due to recent stress in the banking system (i.e., Silicon Valley Bank, Signature Bank, etc.), and the growth outlook has gotten worse. The market has bounced off of the lows of last October, in anticipation of the Fed lowering interest rates and avoiding an economic slowdown. A U.S. recession this year is not a guaranteed, but weighing the evidence as we see it, we believe a recession is still the most likely outcome.
In an economic recession, it is almost certain corporate earnings will decline. S&P 500 index earnings typically decline around 15% to 20% (peak-to-trough) during economic recessions, as both sales growth and profit margins compress. In a mild recession, the earnings decline might be closer to 10% to 15% yet, the current consensus earnings expectations for 2023 do not reflect nearly that magnitude of decline; nor do current stock market valuations. In other words, we do not believe U.S. stocks are adequately discounting the likelihood and severity of an oncoming economic and earnings recession. If our base case earnings recession scenario plays out, there is a strong likelihood that the S&P 500 index will decline from current levels.
Longer-term, looking out over the next several years, our expected returns for U.S. stocks are in the mid-single digits over the period, which assumes a recessionary bear market happens. This is a decent, but not great expected return for U.S. stocks given their risks. It is also well below our five-year return expectations for developed international and emerging markets, which are in the high single to low double digit annual average returns.
Among the three regions, we tactically favor EM stocks right now based on their higher expected returns, which are a function of what we expect will be faster sales growth and improving profit margins over the next several years. This comes after more than 10 years of stagnant EM earnings growth. We also expect some narrowing of the historically large valuation discount between EM and US indexes.
Finally, we expect the U.S. dollar to decline versus most other currencies over the medium-term, which would further add to EM and international equity returns for dollar-based (unhedged) investors. A declining U.S. dollar has also historically boded well for gold positions. When the U.S. stock market declines to levels that offer more compelling medium-term returns and adequately discount shorter-term risks, we will look to add back exposure by selling more-defensive assets (bonds).
We believe 2023 will present us with some excellent long-term investment opportunities. Unfortunately, in our base case we also expect we’ll first have to go through a recessionary bear market with a likely meaningful drop in global equity prices. While a recessionary bear market is our base case, we do not rule out the possibility the U.S. economy avoids recession this year, or that the recession is mild, and stocks do not drop as sharply as we expect.
A lot still depends on the Fed and how much further they tighten (raise rates). If the Fed pauses their hiking campaign sooner than later, equities may positively respond (at least over the short-term), as lower interest rates imply higher P/E multiples. But there are numerous other key variables for the economy and financial markets that are beyond the Fed’s or any policymaker’s control. The recession may be pushed out to 2024, but we doubt it’s been rescinded.
Even with a recession as our base case near-term scenario, we currently see attractive medium-term expected returns from international and emerging markets stocks – better than what we expect from the U.S. market. As such, we have a relative overweighting to equities outside the U.S.
Fixed-income assets and high-quality bonds are also now attractively priced with mid-single digit or better expected returns, depending on duration and credit quality. Core bonds will also provide valuable portfolio ballast in the event of a recessionary bear market. Our investments in alternative strategies and managed futures funds should provide further resilience to our portfolios.
As always, we thank you for your trust and welcome any questions you may have.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, iM Global Partner Fund Management, LLC (“iMGPFM”)
*US large stocks (S&P 500 Index), US large cap growth (Russell 1000 Growth Index), US large cap value (Russell 1000 Value Index), US small stocks (Russell 2000 Index), (Developed international stocks (MSCI EAFE Index), Emerging Market stocks (MSCI EAFE EM Index), Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index), Floating Rate Loans (S&P/LSTA Performing Loan Index), US Dollar (DXY Index), Gold (Aberdeen Physical Gold ETF), Commodities (Bloomberg Commodity Index)
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