Are we on the verge of a recession?
With 2022 almost in the rear-view mirror, it is necessary to start thinking how to position ourselves for the first half of the coming year. Throughout 2022 we have experienced the dramatic effects hawkish monetary policies have when you try to control inflation. These monetary policies affects economic growth, companies valuation, capital availability, and employment.
If we could define the current moment, I would say we are at the “start” of a formal recession. At a very high level, the definition of a recession contemplates economic decline and an increase in unemployment. This last factor, unemployment, has been elusive during 2022 but, little by little, we are starting to experience it. https://www.nbcnews.com/tech/tech-news/another-tech-bubble-bursts-2022-brutal-silicon-valley-workers-rcna56435
How bad can a recession be? Hard to predict. A positive scenario considers a mild recession with a “V” shaped recovery bottoming out in the middle of the year. A negative scenario considers a more complex recession with a "L"shaped recovery lasting all 2023. Nevertheless, no matter the scenario, it is important to be prepared.
When defining an investment strategy for a portfolio, part of the decision making process is based on understanding stock market's valuation, its industries, and especially individual companies, which includes, among various other criteria, growth expectations and earnings.
Every quarter during the financial reporting season, publicly traded companies present two key elements to the public: 1) their financial results for the quarter just ended and 2) their next quarter expectations. This information is vital to have a clear vision of what to expect in the short-medium term. https://insight.factset.com/sp-500-now-projected-to-report-a-year-over-year-decline-in-earnings-in-q4-2022
During the last reporting season (Q3 2022) we were able to observe that the results were acceptable but the expectations for the coming months are unattractive, which include massive layoffs, and economic sectors slowing down significantly (i.e. real estate market). https://www.cnn.com/2022/11/10/investing/premarket-stocks-trading.
In short, they are telling us that the effects of inflation are yet to be seen.
In retrospective, we can assume that the next few quarters will be representative of what the Federal Reserve is looking for (to bring down inflation by reducing consumption) and we will continue to see a hawkish monetary policy with a short-term interest rate increasing by the range of 5 ½% for the year 2023 (today in the range of 3.75%-4.00%) and a stock market seeking to adjust to this new market reality. https://www.forbes.com/sites/billconerly/2022/11/10/interest-rates-going-up-even-more-in-2023/?sh=d210547546a3.
Given this, how can we position ourselves during the next semester?
Investing in these times of recession is complex and will depend on the level of risk and investment objective of each investor.
Fixed income instruments are starting to look attractive. Short-term US Treasury (1 year) averages returns of 4.74%, a very attractive option for the most risk averse. From a risk perspective, the effect of interest rate rise on bonds (duration risk) will be less dramatic than during 2022 but, in contrast, a company's payment capacity (credit risk) will be increasingly relevant.
The stock market is going to be a roller coaster, the results of the coming quarters will reflect the effects of restrictive monetary policies and inflation taking a toll on companies earnings. Our expectation is that the S&P500 will fall back during the first half of the year to levels that could range between 3,500-3,000 and then begin a progressive stage of recovery. https://finance.yahoo.com/news/a-sneak-preview-of-wall-streets-2023-stock-market-forecasts-193943187.html
Investing in the fixed income (bonds) and stock markets will require a defensive approach to avoid surprises. The focus will be on sectors, industries, and companies that during times of recession demonstrate operations discipline, working capital efficiency, low debt and consistent cash flow. Sectors such as Health, Consumer Staples, Energy, and Finance show strengths while sectors such as Technology and Consumer Discretionary will continue to be the most affected.
Commodities, and especially oil, will maintain their speculative trend. Ukraine's war, China's slowdown and zero-Covid policies, OPEC's production cuts (and specifically Saudi Arabia) will make the energy sector a volatile but attractive one. Gold will be tied to the strength of the US dollar with a downward trend through 2023. Today, the stock market is taking a breather from its October 2022 lows, but its bear market nature will continue through 2023.