After a fairly crushing year for equities and bonds in 2022, equities rallied in the first quarter and have had a largely positive earnings season thus far. Recession risk still looms large, however, and with banking tightening now added into the mix, it’s led to a lot of market turmoil and investor uncertainty. I had the chance to sit down with Kathy Bostjancic, chief economist, SVP at Nationwide, to talk about the macro picture and how advisors and investors should think about risk and their allocations for the remainder of the year.
Recession Risk is Top of Mind
Karrie Gordon, staff writer, VettaFi: Kathy, it’s so wonderful to chat with you today. I’m very interested in your perspectives on the macro picture and your outlook for the second half of the year. Let’s jump right in and start with recession risk: you’ve indicated we are in a late-cycle economic period with recession signals continuing to grow on a number of fronts. Can you step through what indicators you’re watching?
Kathy Bostjancic, chief economist, SVP at Nationwide: Those are really good questions. Firstly, yes, we do think we are in the late portion of the business cycle — a number of leading and coincident indicators suggest that.
For instance, the yield curve has been inverted for a very long period of time, but it’s not just financial variables. It’s real-time measures of economic activity too: we’re seeing things like new orders as part of the ISM Manufacturing Survey have declined for five months straight. That’s the longest stretch we’ve seen since the Great Financial Crisis, actually.
Interestingly, suppose you look at the Conference Board’s Leading Economic Index, and you look at the ten underlying subcomponents. In that case, only two of the ten have increased over the last six months: one is the equity market, which is interesting, and the other is manufacturing orders — durable goods and orders for consumer items. The consumer is still afloat, and it’s the labor market that’s powering the consumer.
I am surprised about how impressively resilient the equity market has been in the face of rising headwinds. We still see the likelihood of a sizeable correction in the S&P 500® Index as earnings growth deteriorates further in the second half of this year as we foresee a recession unfolding. That said, given the equity market is a leading economic indicator, it does provide upside potential to our recession call.
The Risk Factors Signaling Recession
Gordon: So, looking at all of these indicators, in your opinion, are we staring down a recession, and if so, has a probability and risk of a deeper recession increased in the wake of banking sector stress and tightening?
Bostjancic: While I like to watch all the leading indicators, what is clearly holding things up and what is really important is the labor market. It’s the big barrier preventing the economy from tipping into recession. If the labor market continues to hold up, earnings tread water, and corporations do ok, then you would avoid a really hard landing.
Our view is that’s not going to be the case; in fact, we are starting to see some cracks in the labor market now. If you look at leading indicators such as initial jobless claims, we’re starting to see a little increase. Most recently, they have gone from 200,000 to 225,000, which is still really low, but it’s not flashing red yet. We do think as we continue, however, it’s going to deteriorate.
The other big part, of course, is labor and income fuels consumption, but we’re watching what’s happening with the consumer. We saw the consumer fade away in February and March, but January was so strong that it lifted the whole quarter.
Real consumer spending was up 1.5%, partly because warmer weather brought forward some of the spending normally happening in February and March. However, I think consumers are feeling some fatigue. Inflation is still elevated, interest rates are high, if not going higher, and income expectations are deteriorating.
With banking sector stress, we had a moderate recession forecast even before the latest stresses. Now, with the second or third largest bank failures ever in U.S. history, it would be very unlikely if we don’t see a very large tightening of bank lending standards. The question is how much and for how long? I think it adds further downside risk for us and supports our call regarding a moderate recession in the second half.
Look Defensively When Positioning for Recession Risk
Gordon: You touched on earnings season and I want to explore that a bit further. The market rallied big on positive earnings beats from many industry giants. These large- and mega-cap companies are carrying several sectors higher while banking sector stress is pulling down the financial sector.
There’s this pronounced equity dispersion that’s been happening, and that seems like it might get even wider. Because of concentration risk, is there anything you feel advisors should be watching for and thinking about within equities, particularly in light of looming recession?
Bostjancic: Given our view that we’re in the latter portion of the business cycle and on the precipice of recession, I think if you’re invested in the equity market, defensive sectors are where you should be. Traditionally that’s sectors like consumer staples, but you want to be very careful about things that are a little risker, like small caps, for instance.
Based on our view, companies that offer a good dividend return are higher quality, safer investments in the equity market. It makes sense to park there until we can get some clarity.
Prepare for Downside Risk and Keep Your Powder Dry
Bostjancic: The bad news is we think there’s further downside potential for the equity market, and it could be significant; the good news is that because equities are a leading indicator, they tend to rally about two-thirds of the way through a recession and when you get set up for a very strong rebound.
Thinking about that, we would suggest advisors talk about structuring their portfolios to be defensive: keep your powder dry now but be ready to pivot at some point. We don’t think that will be until the end of this year or early next year, but you can be patiently waiting within these equities, getting dividend yields, or even in bonds.
Given bond market yields, short-term Treasury bills are providing opportunity — right now, a 3-month T-bill is 5% — and even the Two-Year Note if you want to lock in for that long. T-bills are nice because you don’t pay state and local taxes on that, and it has a pretty attractive yield right now. Getting into those on the fixed income side would give you time to keep your power dry for a potential equity rebound.
Sticky Inflation Likely to Continue Into 2025
Gordon: Switching gears a bit, let’s talk about inflation. Broad inflation is falling incrementally this year, but core inflation continues to rise, and that’s a concern. It’s putting a squeeze on consumers: the Consumer Confidence Index fell in April. Even more telling, the Expectations Index, (measures short-term consumer outlook for businesses, income, and the labor market) dropped to 68.1 in April from 74 in March.
In all of this, the Fed has been the great unknown alongside fears of sticky and persistent inflation in the last 12 months. Where do you see the narrative going from here on inflation and rate hikes?
Bostjancic: I think the data has shown, and it’s been in line with our view, that it’s going to take time to bring down what has so far been very persistent and sticky inflation, particularly on the services side. Our view is that’s going to continue to be the case.
The only part of the inflation story that was actually transitory, as the Fed had expected, has been the goods sector. Even then, last month, we started to see a small uptick in that. Housing, rental price inflation, has been screaming at 8.2%: that should start to roll over because new rental leases will have fewer price increases, and the gain in home prices has moderated.
Persistent Services Side Inflation Not Going Away Soon
Bostjancic: It’s the services sector, costs excluding rentals or housing, that super core services number that Chairman Powell told us to look at. Whether you look at CPI or PCE, it doesn’t matter — you’re seeing very little disinflation in that super core services number. That’s where lies the problem.
It’s a factor of companies and sectors on the services side feeling that they have pricing power and can maintain purchasing power, but also a reflection of consumers continuing to spend. We’re still catching up from the pandemic and feeling pretty strong about dining out and traveling.
What’s happening is if you look at the savings rate, it’s rising. Consumers feel the need to be more conservative and not spending all of their income. When we get past the summer splurge and head into the fall, there will be this reconciling of consumers saying, “Ok, I caught up, did some traveling, I’ve been eating out during the nice weather, but now I need to hunker down.”
That’s our view, and that will feed back negatively on revenues. Companies that think they have strong pricing power are still facing relatively buoyant wage growth. That will hit profit margins and cause them to shrink, eventually leading to lower earnings growth. That, in turn, will prompt a reduction in hiring and/or layoffs, which is already happening in some sectors.
All of that, alongside the recession, will lead to inflation coming down, but it will be pretty gradual and sticky — you just can’t get service-side inflation down that fast. It could take several more years, two more years at least, we think.
Banking Sector Risk Likely a Mini-Crisis
Gordon: One last question before we go. Should advisors and investors be thinking differently now in response to bank risk and potential volatility that bank stress in the coming months could cause? Or would you recommend continuing to play the defensive sectors and ride things out, a sort of wait-and-see approach?
Bostjancic: I think the latter because it supports that thesis and our view of where we are in the business cycle and where we’re headed. We don’t think we’re in the midst of a systemic banking crisis, but I think a banking crisis depends on how you define it. I heard a commentator earlier talking about each bank failure seeming isolated and idiosyncratic, with a story about each one. The big banks seem to be fine and passing their stress tests; if anything, they will get bigger and stronger in all of this.
I think what’s happening with banks is certainly a phenomenon that will lead to a high degree of tightening lending standards. I don’t think it’s a banking crisis, but it certainly could be considered a mini-crisis.
The Credit Sea Change on the Horizon
Bostjancic: The reason I don’t believe it’s a systemic banking crisis is that it’s not the whole banking system at risk. We hope that the worst is over and that if there were other stresses, they would have come to the surface. Regulation and supervision are going to get a lot tighter and tougher, which will lead to less profitability for banks and further tightening.
I don’t believe we’re going to see an outright credit crunch, but it does seem like we’re in for a pretty large sea change in terms of credit availability.
Gordon: I appreciate that perspective, I don’t think I’ve seen anyone look at it quite that way — usually, the focus is more on the fear and crisis aspect. Kathy, thank you so much for your time and your insights, this has been really wonderful.
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