It’s a Recession! It’s Stagflation! How to Rebalance a U.S. Portfolio in the Changing Landscape
**All information in this article is current as of November 20, 2022.**
A bear market for both stocks and bonds, the Fed relentlessly raising interest rates, and persistent historic inflation despite it has left even the savviest investors with sizeable losses in 2022. As we look back on the last three quarters and live through the fourth, it is clear that 2022 will go down as one of the worst years in recent history for investors, showing no signs of slowing down. Given the worsening economic environment, one question remains: how can the individual investor prepare for the future?
Currently, there are three primary considerations on each investor’s mind: inflation, interest rates, and economic growth. How one chooses to rebalance their portfolio moving forward will vary greatly depending on their belief in how each of these will progress. Therefore, this article aims to outline three possible views an investor might have for the economy's future and then explore potential rebalancing strategies.
Investing Landscape
The first two considerations—inflation and interest rates—are closely related. Last year, officials such as Fed Chair Jerome Powell and Treasury Secretary Janet Yellen were convinced that high inflation would be transitory. Yet, thus far in 2022, the Consumer-Price Index (CPI) has lingered above 8%, the highest it has been in nearly 40 years. To combat this high inflation, the Fed has taken an aggressive path with interest rates, announcing increases in the Federal Funds Rate of 75 basis points at four of the last six FOMC meetings since March. October’s CPI reading, however, showed an unexpected fall to 7.7%, lower than anticipated by experts and a glimpse of hope for investors. In response to this data, the Fed announced that the next rate hike, scheduled for December, will downshift to 50 basis points. Even so, in the words of Fed Governor Christopher Waller, “…we must be cautious about reading too much into one inflation report…one report does not make a trend.” It is crucial to recognize that we cannot safely conclude that inflation is sustainably headed downward.
The flip side of the coin is economic growth. The Conference Board forecasts that real GDP growth for 2022 will come in at 1.8% year-over-year and slow to near zero percent for 2023. What complicates matters is that after two straight quarters of negative GDP growth in Q1 and Q2, the U.S. saw a positive Q3. However, the bleak forecast is associated with lingering inflation and increasing hawkishness by the Fed.
The Future
It should be ironically clear by now that searching within economic data for clarity on the U.S. economy will not prove fruitful. So, what can be said about the future? A recent Bank of America survey of 272 global fund managers (collective AUM $790bn) showed that a record 85%
expect global inflation to decline over the next 12 months. At the same time, 92% expect a “stagflationary” environment, where economic growth continues to slow while inflation remains above the Fed’s target rate of 2%. This leaves three schools of thought, heavily dependent on the path an investor believes inflation, interest rates, and economic growth will take.
The first scenario is a deep recession, characterized by low economic growth, declining inflation, and declining interest rates. Encountering a deep recession in 2023 relies on two conditions: economic growth continues to decline, and cooling inflation leads the Fed to a turning point—where the rate hikes effectively “top-out”—and subsequently begin to drop. The timing of a recession would likely be later rather than earlier, closer to the end of 2023. However, predicting the timing of a recession is not a science, and is much more difficult than anticipating a recession itself. The largest arguments for a later recession are the ~$1.5tr excess consumer savings due to extensive pandemic stimulus, and an excess demand for labour relative to the number of unemployed people, which will likely lead to companies eliminating open positions before laying off existing workers.
The second scenario is stagflation, characterized by low economic growth, sticky inflation, and rising rates. For stagflation to occur, economic growth must continue to decline, but inflation must remain substantially above the Fed target, resulting in sustained high interest rates. Concerns of a return to 1970s-style stagflation have risen as price pressures remain high and growth slows, despite the Fed’s historically aggressive quantitative tightening.
The third scenario is a “soft landing,” the Fed’s ideal outcome. A soft landing for the economy would mean higher-than-expected economic growth and lower-than-expected inflation and interest rates. Having said that, expectations of a soft landing in 2023 are low. The Fed would need to simultaneously tame aggregate demand enough to avoid rising inflation while ensuring an overcorrection with rate hikes does not occur and harm real GDP, an incredibly difficult balancing act which is complicated by supply chain issues and political instability with the Russia-Ukraine war.
Stocks
With the current landscape characterized and potential scenarios laid out, investors can begin to rebalance their portfolios, with the obvious first consideration being their allocation to stocks. During volatility, there are a few equity strategies that stand out, and the first is defensive stocks. A select few sectors tend to outperform cyclical stocks during periods of economic uncertainty and high inflation, primarily due to their inelasticity of demand and/or positive correlation with inflation. Sectors such as utilities, healthcare, residential real estate, and consumer staples perform well because while consumers may hold off on purchasing a new iPhone, they still need shelter, food, and electricity. Historically, the strongest sectors during periods of stagflation have been utilities (+16%), consumer staples (+14.2%), and real estate (+11.8%), compared to their cyclical counterparts such as IT (-6.7%) and industrials (-3.3%); the results are even more pronounced during recessions. Thus, defensive stocks are an attractive option when rebalancing a portfolio for the future. Another option is value stocks. In contrast to growth stocks, which are companies that have strong future growth potential, value stocks are those that are trading at a lower price than what the company’s fundamentals and performance may point to. Companies labelled as value stocks often have stable current cash flows, compared to growth companies which may only have strong future forecasts. As a result, when valuing companies using a discounted cash flow method, value stocks often outperform growth stocks during periods of high inflation (and subsequently high interest). As a whole, during a recession or stagflation, value stocks are easier to find due to the equities market as a whole being driven down, thus making them an enticing option for investors looking to rebalance their portfolios. However, the main risk with value stocks is that the company must eventually emerge from its undervalued position to generate returns; if the market never realizes what an individual investor does, this may never occur.
Bonds
The second allocation to consider is fixed income, or bonds. At the most basic level, when interest rates go up, bond yields go up, and when yields go up, prices go down. This principle has meant that ever since the Fed shifted its focus to fighting inflation rather than supporting markets, bonds have performed incredibly poorly. With the Bloomberg U.S. Aggregate Bond Index down 13.25% YTD, bonds are poised to post their second consecutive year of negative returns—something that has never happened before. However, with a disciplined investment strategy, a bear market for bonds presents opportunities. The current source of volatility in the market is driven by uncertainty regarding the Fed’s tightening strategy, instead of the typical fundamental factors that normally drive investors to bonds. In other words, a compulsion to sell bonds due to rising rates may be omitting attractive coupon payments, and with yields up and prices down, low-risk bonds are at bargain prices even as they pay record-high yields. If an investor’s primary goal is to meet fixed-income needs, bonds may be the place to be. Another consideration is the ability to reinvest coupon payments and maturities at higher rates. When a bond yield is quoted, it assumes that coupon payments are being reinvested at that yield. Systematically reinvesting coupon payments as rates remain high can enhance total returns while reducing risk. Overall, focusing on forward returns is key. Depending on an investor’s outlook, the opportunity to increase their allocation to bonds for maximum returns may not be there if they wait too long. When the Fed eventually slows rate hikes as inflation trends down, bond prices will bottom out and begin to rise again, signalling the potential end to the bear market. Moreover, as inflation trends down to the Fed’s target, real returns (yield minus inflation) could gradually rise into more positive territory.
During times of uncertainty, some investors may consider reallocating a larger percentage of their portfolios to cash, but this comes down to individual investing goals. One of the clear pros to holding cash at this time is that with rising interest rates, savings and money market accounts are providing higher returns. On the flip side, while a MM account may be providing nominal returns of 4% on each dollar saved, sticky inflation around 8% means that real returns are closer to -4%, and the cash is still losing purchasing power. Another pro is that cash accounts are low risk; $1,000 deposited today will still be $1,000 in a year, a guarantee that cannot be had in the stock market. Yet, cash on hand has an associated opportunity cost since it is not actively providing returns—a trade-off that investors must constantly make when choosing to balance risk and reward. The final major pro for holding cash is that during volatility, market dips will occur often in a variety of sectors. Choosing to build excess cash holdings now may mean that when opportunities arise, investors have ready capital to use. Take bonds, for example; if an investor believes that the Fed is going to continue raising rates as outlined in scenarios one and two, and that these rate increases are not fully priced in, it may make sense to hold cash now and wait until bond prices bottom before purchasing. However, buying a dip is not as simple as it sounds; an investor may buy too early, too late, or miss it altogether, all of which will eat away at returns.
Takeaways
Two key takeaways remain when examining how to rebalance a portfolio, despite one’s economic outlook.
The first is to always have an up-to-date understanding of where the market is, or in other words, a current scenario analysis. The crux of investing in a changing landscape is learning how to thrive in volatility, the key to which is understanding where the opportunity is. If an investor is not constantly updating their scenario analysis, they cannot hope to find this opportunity.
The second is independent thinking. As the saying goes, the market can price good and bad news, but not uncertainty. Thus, in a period where the consensus is that there is no consensus, the number one way to avoid falling into bear traps is to remain independent in one’s thinking.