05/22/2023 | News release | Distributed by Public on 05/22/2023 05:19
If you're an optimist, earnings season was broadly encouraging for investors. Companies did better than their lowered expectations and held to the view that trends remain better than feared.
Likewise, job growth is still positive despite higher rates, housing has rebounded, and consumers continue to spend, although they are "trading down" as inflation bites.
From this perspective, the Fed might successfully guide the economy to a "soft landing," meaning that we may even avoid recession as inflation comes down to tolerable levels.
If you're a pessimist, you'll note the bond markets continue to forecast recession, as the yield curve remains inverted. The stocks of regional banks are down dramatically since March, reflecting concern that higher rates and bad debt in real estate loans will take a toll. And inflation remains elevated even as growth might slow.
From this view, there are plenty of overhangs to any positive news.
Which side is right? In this note, we put these points in context and provide our take.
Taking the long-term perspective, our expectations continue to be:
The Most Anticipated Recession in History?
Markets have been forecasting recession since as much as a year ago. It hasn't happened yet, and economic activity remains solid overall. Why is recession taking so long to get here, if it does at all?
The simple answer is that there is a lag effect to rising rates, which we have discussed, perhaps as much as six to 12 months.
But there are factors this time around that we believe are pushing the lag out even further and softening the impact of rising rates:
These factors may help buy time for the economy to absorb higher rates and adjust without crashing. But we do not believe they fundamentally change the dynamics of inflation and how to contain the threat.
Impact of Higher Rates Starting to Show
Despite headline strength in labor markets, we believe cracks are starting to show from the rapid increase in rates. Higher rates have:
With this backdrop, it is no surprise that banks' lending standards have already become much tighter. Higher rates affect bank profitability if banks need to raise yields on deposits or if loans go bad. It is harder to get credit these days for many small and medium-sized businesses.
Tight lending standards generally lead to slower economic activity. Notably, the number of banks reporting tighter standards is beginning to approach levels seen during the last four recessions (1990, 2001, 2008, and 2020).
We anticipate that tighter lending conditions will once again have a meaningful impact on broader economic activity later this year. The fact that debt secured by commercial real estate matures in stages over the next four years may help spread the pain of workouts and economic dislocation.
Recap: Our Recommendations
We started making defensive adjustments to investment strategies over 18 months ago as certain risks were becoming imbalanced.
To highlight our research decisions during this period:
During this period, we have also been counseling business owners, families, and nonprofits about the rising risk of recession, and how to adjust as necessary.
We don't recommend a change to investment strategy for our clients at this point, if your circumstances have not changed.
Any questions or concerns, please let one of us on your team know.