Are We Having a Recession Or Not?

This article has been excerpted and edited from our quarterly newsletter to clients dated February 14, 2023.

Most think so. Some foresee a soft landing—where the economy barely skates through. Few have no opinion. It’s one of the most important questions investors must ask because stock markets usually fall dramatically from the impact of a recession. Will we have one? We think so.

Globally, growth is waning, though at a tepid pace because of the prior avalanche of government stimulus, rebuilding of supplies, and extremely low unemployment. Will central bank restraint lead to a mere petering out of growth, if inflation is quickly perceived to have been ameliorated, or is recession inevitable from one of the fastest tightening responses on record?

Even if there is a change in perception that inflation has been tamed (which we believe should be the case), the authorities likely won’t loosen since they’ll be worried about reigniting inflation, as they did in past cycles. Therefore, while short-term administered interest rates may be close to peaking, we don’t expect declines in the near term, unless the economy experiences a harsh decline. Meanwhile, food prices remain stubbornly high, and a good portion of the recent slowdown of inflation was attributable to the dip in gasoline prices, which are now rising again since the oil market is tight. Even excluding food and energy, inflation is too high.

Gone are the days of zero-interest rates policies, and the negative rates that absurdly occurred in some jurisdictions. Yet security valuations have not sufficiently adjusted, especially considering the prospect of a recession and already declining corporate profits. And central banks certainly don’t wish to rekindle the speculative fervour that accompanied such low interest rates.

Good News Isn’t Good News

Remarkably, despite most believing a recession is imminent, investors’ attitudes could best be described as nonchalance. Perhaps because inertia is a powerful force, and most are reactive. Or while unemployment is so tame and consumers are in such good shape, most aren’t worried about its impact on themselves yet. But good news is bad news, at least economically right now, because for example, central bankers are concerned that a tight labour market (near record-low unemployment) could lead to undue wage inflation (ADP figures just showed a 7.3% annual increase and much higher for those changing jobs), and a further overall impact on prices generally, especially in services where inflation is still rising.

Corporations have been able to pass along price increases. Customers have accepted them. A psychological shift that we haven’t seen in years. The services side of the economy represents about 60% of the CPI. Though it’s terrific, despite the triple-threat of covid, RSV, and the flu, illnesses are down from last year, the services economy is now flying with everyone emerging from their covid cocoons. Expect central bank tightness to remain, leading to lower aggregate demand. Unemployment bottoms just 2-3 months prior to a recession—risk of one remains high.

Caution Signs

Central bankers keep saying they’re not done raising rates. Fed Chairman Jay Powell just said, “We’re not yet at a sufficiently restrictive policy stance, which is why we say that we expect ongoing hikes will be appropriate.” And the Fed minutes show unanimity against cutting rates this year. In Europe, Central Bank President Christine Lagarde noted that they intend to aggressively raise rates until inflation is below their 2% target.

Dislocations have started from higher rates. New home building cancellations in the U.S. were extremely high in Q4 as buyers opted out. Astonishingly, prices of detached homes in Toronto have declined by 18% in the last 12 months.

The World Bank is forecasting for 2023 the weakest global growth rate in 30 years, other than the Great Recession of ’08/09 and the 2020 covid-lockdown. While the Atlanta Fed, who’s proven to be rather accurate, estimates real U.S. GDP growth this quarter of 2.2%, economists, on average, expect the U.S. to grow by only 0.1% in Q1 and contract by 0.4% in Q2. Already, 27 U.S. states are experiencing negative growth versus an average of 26 at the beginning of the last 6 recessions.

Companies are feeling the pinch. And while rightsizing has begun in the form of hiring-freezes and layoffs, profit margins should be impacted by slower sales volumes and higher input costs. Each of Wal-Mart, Target, and Amazon have increased hourly wage rates for front-line workers (we can almost tell the kids to stop rallying for minimum wages since capitalism is working). Many tech companies have been announcing substantial layoffs to both right-size for the current environment and contain costs generally.

Demographics in most developed countries still point to slow growth as population growth is anemic. Even in China, the primary global growth engine, its population fell in 2022 for the first time since the ’60s.

Debt at all levels of government in most developed countries remains way too high, and more burdensome as rates rise. Despite this, government spending remains excessive, especially relative to the prospect of lower recessionary-induced tax receipts. High debt levels also act to stifle growth since there’s a limit to its expansion. At the corporate level, lending standards have already tightened which should impede new debt financing and, in turn, growth.

Excess savings of U.S. consumers are expected to dry up around the middle of this year. And industrial commodity prices as well as used car prices have fallen significantly in recent months, both indicators of a recession.

Our Economic Composite (TEC^TM) triggered a negative signal in October for the U.S. TEC^TM has historically forewarned of a recession, on average 10 months prior to the peak in the business cycle without a false signal. We’ve also had negative signals for Canada, Germany, and the U.K. A synchronized slowdown in many nations around the world is concerning.

Historically, when the LEIs (U.S. Conference Board’s Leading Economic Indicators) were negative and falling, as they are now, a recession invariably occurred, and the stock market declined at an annual 11% rate. However, when the LEIs are still negative but start rising, returns average 30%. Hopefully that infection point isn’t too far off. Our optimistic nature is trying to find the silver lining, but we’re grounded by realism and continue to err on the side of caution.

Broken Tripod

Currently, all 3 major components of calculating fair market value (FMV)—earnings, growth rates, and interest rates—are heading in the wrong direction.

Even more reason that our preferred investments are self-sufficient—those that have free cash flow, a solid balance sheet, competitive advantages, and an attractive growth profile. Not companies that are dependent on the markets for success. Last year, many businesses that were unprofitable or over-levered suffered material share price declines when their access to capital evaporated. While an investment should benefit from others ultimately bidding it up in price as the underlying fundamentals justify so, it should not be reliant on other people’s money to keep the business afloat, with the mere perception that it’s an exciting opportunity—that’s a speculation.

We look to benefit from a gravitational pull up toward fair value. And avoid the eventual plummet in speculative companies when hype fades and FMV support is absent.

But we are concerned about a recession which brings job losses, falling asset prices, and credit issues (i.e., debt defaults).

For the Nasdaq and S&P 500, the current price-to-earnings multiples of next-12-month estimated earnings is about 25% and 13% above their respective 20-year averages, despite higher interest rates (which lowers values), the prospects of a recession, and earnings estimates that are already down 10% from last year’s peak for the Nasdaq, and just over 5% for the S&P 500.

And few sectors are beaten up enough to pique our interest. One analyst we follow is warming up to Ukrainian real estate. Don’t worry, even we aren’t that contrarian. He’s serious, and it’s an interesting argument for many reasons, once the war ends. Again, don’t worry, there’s enough in our opportunity set closer to home.

Market Reactions

Our relative indicator of momentum, TRIM^TM, which normally triggers after our Economic Composite, signaled for a market decline in the U.S. starting in May of last year when index prices fell below key levels. The recent market rebound has been testing the top of our TRIM^TM bands, but prices appear likely to turn back down.

Markets are richly valued and remain too high particularly relative to interest rates. Call option buying is at a record high—speculation has picked up again, leaving most markets overbought.

The U.S. dollar is oversold. The Euro is overbought. Gold bullion is overbought, and too high relative to the average cost of production. Bitcoin has run up suddenly. And the most heavily shorted stocks are this year’s winners, up over 30%. None of this is healthy for stocks.

And surprisingly, the credit spread between U.S. high-yield and government bonds has only been this narrow (i.e., overlooking risk) on 5 other occasions over the last 100 years, and all preceded a recession where spreads then widened dramatically. Furthermore, investment-grade corporate bonds now yield less than T-bills, which is extremely unusual. Yields on cash balances finally offer a decent return, though not a real return—still below inflation.

Our Strategy

While most believe a recession is coming, it appears few have yet to react. For us, it paid to be defensive last year when markets declined. By way of example, U.S. stock indexes and U.S. 10-year government bonds both fell by double digits—a first.

The bear market has paused over the last several months. Stock markets have rallied strongly while the economy has held up, despite high valuations and the potential for recession.

With our TEC^TM alerting us to a recession and our TRIM^TM alerting us to a bear market, we remain with reduced exposure to the market. We expect to keep a hedge in place until markets have declined sufficiently to discount the impact of a recession, or the macro environment has a complete about-face.

It would be precedent setting for next-12-months’ earnings estimates for tech stocks to have fallen, as they have, without a recession ensuing. Thus, we expect earnings to decline further as the economy worsens.

That said, most of our portfolio holdings have growing earnings, generally because the businesses we hold aren’t cyclical. And our holdings are also undervalued compared to our FMV estimates. We hold and continue to add positions in companies that we believe can withstand an economic downturn and be even more valuable after a recession. We have prized businesses with essential products or services, whose balance sheets are clean or manageable, and returns on capital are attractive.

We are always on the lookout for quality companies that have detached from their underlying FMVs, usually because of short-term issues or misconceptions. A declining economy should bring uncertainty and market dislocations—opportunities to invest in high-quality companies that have been temporarily discarded.

All Bad Things Must Come to an End

We expect a recession. Our Economic Composite, TEC^TM, has warned us that the business cycle is about to peak. It alerted us in 2019 to the pending 2020 recession—and in a backtest dating back to the ’60s alerted to all 8 previous recessions. Central bankers continue to tighten, essentially trying to engineer a recession, just not a severe one.

Oddly, market valuations remain relatively high. Therefore, we continue to have patience during a period that feels particularly elongated. We have been culling certain holdings and adding other ones—undervalued high-quality businesses—when the risk/reward setups are favourable.

Markets rarely fall for 2 consecutive years. And it may be the case that this isn’t a down year. However, the path to us still appears highly uncertain with the prospect of a recession soon and the lower market prices that traditionally accompany economic declines. And while markets might be anticipating the peak in interest rates, the material portion of the market’s decline isn’t typically until the central banks first lower short-term interest rates, in response to economic decline.

The good news is that recessions don’t usually last very long as the cleansing period is relatively quick. In the interim, we’ll wait for the onset of a recession, for the bad news to be discounted, sufficient investment opportunities to be presented, the prospect of higher returns to be resurrected, and our portfolios to once again be fully invested.