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The Next Recession: Preparing for Uncertainty

By on July 1, 2022
Categories: MARKET NEWS

“If you find it puzzling, your brain is working correctly.” -Charlie Munger

Financial markets and the economy are mystifying at times, even to the most seasoned investors.  Ongoing domestic and international disputes – coupled with lingering effects of the multi-year pandemic – continue to instill feelings of instability and angst amongst investors.  The second quarter brought numerous economic and geopolitical events into focus:

  • The stock market (measured by the S&P 500 Index) officially entered a bear market, defined as a 20% decline from the most recent all-time high. This is the fourth bear market since 2000.
  • Inflation hit its highest level (again) in over 40 years with the Consumer Price Index (CPI) rising 8.6% in May (from the previous year). Rising energy and shelter/housing costs contributed the most to the increase in CPI.
  • The Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) increased the target range for its federal funds rate by 1.25% during the quarter, including a 0.75% raise in June – the largest increase since 1994. Bringing down high inflation without tipping the economy into a recession has proved to be a challenge for the Fed.
  • The average interest rate on a 30-year fixed mortgage crept over 6% for the first time since 2008, about double what it was just one year ago.
  • After heavy, coordinated economic sanctions from western nations, Russia defaulted on its foreign debt – the first time doing so in over 100 years.

Second quarter returns for equity and fixed income asset classes were lower across the board:

 

Index

 

Asset Class

 

Second Quarter 2022

 

Year-to-Date 2022

Barclays U.S. Govt./Credit—Int. Fixed Income -2.4% -6.8%
S&P 500 Large U.S. Stock -16.1% -20.0%
Russell 2500 Small/Mid U.S. Stock -17.0% -21.8%
MSCI ACWI ex-USA IMI Foreign Stock -14.3% -19.1%
S&P Global REIT Real Estate Securities -17.2% -20.4%

Source: Dimensional Returns Web

With the U.S. stock market dropping into bear market territory and high inflation affecting consumers and businesses, many investors are now asking whether an economic recession is imminent.  What exactly is a recession?  The word itself may conjure economic turmoil, with people losing jobs and falling asset values.  The actual definition of a recession, however, is a bit murky.

Here is how the National Bureau of Economic Research (NBER) defines a recession:

“A recession is the period between a peak of economic activity and its subsequent trough, or lowest point […] The NBER’s definition emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” (www.nber.org/research)

Since the end of World War II, there have been a dozen recessions in the U.S. lasting about 10 months on average – some longer and some much shorter (the recession of 2020 lasted only two months!).  It’s not uncommon for investors to think of the economy and the stock market as one and the same, but they are certainly not.  The economy and stock market are not always synchronized, and, generally speaking, news investors receive about the economy (unemployment levels, GDP growth, corporate earnings, etc.) reflect data and events that have already happened.  We will likely already be well into a recession by the time it becomes official.  Financial markets tend to decline in advance of a recession and start to rise before the economy improves.  As detailed in the table below, the good news is, after a recession, the stock market generally does well over long periods of time:

Recession table

The current market environment shares similarities with the dot-com boom and bust of the early 2000s.  In the “boom” portions of each cycle, technology stocks soared at a seemingly unsustainable pace, getting far ahead of actual earnings.  Speculation in stocks of unprofitable companies was rampant and day trading became a popular pastime.  In the “bust” portion of each cycle, these same technology and speculative stocks fell quickly back to earth.  The magnitude of the dot-com stock market correction was greater than the current correction.  However, it is stunning to see some of the quick downturns in once high-flying stocks and speculative asset classes this year.  Bitcoin, for example, is down over 57% through June 30, 2022.  During this same period, the components of the widely followed “FAANG” stocks (Meta Platforms, Apple, Amazon, Netflix, and Alphabet) are down 52%, 23%, 36%, 71%, and 25%, respectively (Source: YCharts).

What is different about today’s market environment is there does not appear to be just one single cause to the market correction, but multiple factors.  Looking back at the last several downturns, it is easier to pin down one or two primary causes.  The market crash of the early 2000s can be attributed to a speculative technology stock bubble that inflated and popped, the Global Financial Crisis of 2007-2009 was largely due to easy credit and lax lending standards that ignited a housing bubble, and the most recent 2020 stock market downturn stemmed from the economic impact of the global shutdowns at the onset of the COVID-19 pandemic.  Today, a myriad of factors is affecting the economy and market: high inflation, the conflict between Russia and Ukraine, the Fed raising rates at a feverish pace, global supply chain issues, and factory shutdowns from some of our major trading partners (e.g., China) due to the ongoing pandemic.

Market conditions could get worse from here – or the worst may already be behind us.  Although it is nearly impossible to predict the exact timing of the next recession, there are a few historical gauges that have indicated a looming recession in the past:

  • An inverted Treasury yield curve. A Treasury yield curve is the graphical depiction of the yield of fixed-income securities issued by the U.S. government plotted against their length of time until maturity.  When short-term interest rates exceed longer-term interest rates, this is referred as an “inverted” yield curve.  In such situations, the bond market may be warning of slower growth ahead.  The last several recessions have been preceded by the yield curve being inverted with the 10-year Treasury yield less than the yield on the 2-year Treasury.  This, however, does nothing to tell us if or exactly when the next recession will happen.  We have experienced an inverted yield curve on more than one occasion this year, albeit for brief periods of time.
  • Rising unemployment. With consumer consumption representing about two-thirds of U.S. economic output, fewer people working generally means less discretionary income and therefore reduced spending which could result in an economic slowdown.  Today, unemployment is historically low (under 4%) and job openings still exceed the number of job seekers by a wide margin.  In recent months, however, many companies have announced layoffs and a slowdown in hiring.
  • Declining corporate profits. Declining profit margins may lead companies to cut investment, wages, or jobs.  Corporate profits have increased dramatically since bottoming out during the worst of the pandemic.  Companies are now dealing with the highest inflation in over four decades.  Some will be able to successfully raise prices, but increased costs will likely put pressure on profit margins in the long term.

So, what are some scenarios for where the economy and stock market go from here?

  1. We could very well already be in a recession already. Since there is generally a lag in the official declaration of a recession, we may not know we are in one until after the fact. In the 2020 recession, for example, the S&P 500 Index hit a bottom on March 23rd.  The official recession was not “called” until several months later in June.  In the dot-com crash, the S&P 500 Index hit a low point in September 2001, but the recession was not announced until November of that year.
  2. We could avoid a recession for now but enter one later. The Fed could be successful in easing inflation and achieve a “soft landing” with the economy.  We may avoid an “official” recession for the time being, but it would only be a matter of time until we enter one in the future.
  3. Something unpredictable happens. Negative events like a new war – or the expansion of the conflict in Russia/Ukraine – could occur.  A brand-new pandemic could unfold. The Fed could keep raising interest rates and lose the battle of taming inflation.  On the other hand, we could have an abrupt end to the Russia/Ukraine conflict, the pandemic could come to an end, inflationary pressures could ease on their own, or supply chain issues could resolve more quickly than anticipated.

While we do not attempt to predict the short-term direction of the stock market, we remain optimistic about the long-term outlook for both the U.S. economy and equity investments. Stock market valuations are now becoming more reasonable with the S&P 500 Index trading at about 16 times forward earnings, slightly below its long-term average (contrast this with stocks trading at approximately 30 times earnings in early 2000).  U.S. corporations are still sitting on historically high levels of cash, which will eventually be used for capital investment – or to provide a buffer during a recession.  The stock market may not turn around this month, this quarter, or even this year.  Nonetheless, for investors with long time horizons and with the emotional wherewithal to tolerate the inevitable ups and downs, we believe that stocks will continue to generate attractive long-term returns.

How to Take Advantage of Down Markets

It can be helpful to remember that there is a silver lining to down markets.  Here are several ways you can turn those “lemons into lemonade” while the stock market is lower and economic uncertainty lingers:

  • Fund Your 401(k) and other retirement accounts. Consider accelerating your retirement contributions to take advantage of “buying low.”  While no one can predict what will happen in the short term, over the long term, markets have historically rebounded and moved higher after drops of 20% or more.
  • Explore Roth conversions. If your traditional IRA has gone down in value recently, now may be an ideal time to convert some funds to a Roth IRA, potentially saving you money in taxes owed (the assets you convert will grow tax free).  Traditional IRAs are usually funded with pre-tax dollars.  When you take money out, you pay taxes on those withdrawals at ordinary income rates.  In contrast, Roth IRAs are funded with post-tax dollars.  Money in Roth IRAs grows tax free and is withdrawn tax free if you are over age 59-½ and your Roth IRA has been open for at least five years.  It can be very useful to have tax-free money available in retirement, especially if you also have taxable income from other retirement accounts and/or Social Security. Roth IRAs also pass free of income taxes to heirs.
  • Fund Roth IRAs for your kids. Roth IRAs are also an ideal asset for kids since they have such a long time horizon for those funds to grow.  Kids do need to have earned income to be able to contribute to a Roth IRA, and they can only contribute up to the lesser of $6,000 (in 2022) or the amount they earn.  As a parent, you can open a custodial Roth IRA for your underage children.  You can even contribute to the Roth IRA on their behalf, as long as their earned income at least equals what you contribute.
  • Contribute to a 529 Plan. A 529 plan is a college savings plan.  Funds grow tax deferred, and, if used to pay for qualified educational expenses, can be withdrawn tax free.  Because the funds inside a 529 are invested in the markets, making your 529 contribution now can take advantage of potentially lower prices and higher expected future growth. In 2022, gifts to 529 plans totaling up to $16,000 per individual will qualify for the annual gift tax exclusion.  The IRS also allows you to “frontload” five years of 529 contributions.  That means a couple could contribute up to $160,000 in one year for one child or grandchild without owing any gift tax.
  • Consider making estate gifts now. When market values are lower, it can be more advantageous to give assets to others.  If you are likely to exceed the estate tax exemption (about $12 million per person in 2022), consider gifting some of those assets to your non-charitable heirs now.  You will use less of your estate tax exemption than if you gifted them after the assets recovered. Instead, your heirs may benefit from the future appreciation in the assets.
  • Update your financial plan. As market conditions change, it may be a good time to make sure that you have “stress tested” your financial plan.  Do you know how your plan holds up in bear markets?  What if you decide to retire during a bear market?  What else do you need to plan for in these times?  Consider taking a fresh look at your financial plan to make sure that the road ahead is still pointing in the right direction.

Market volatility can feel unsettling and uncertain.  But by controlling what you can control, you can make sound financial decisions even in challenging times. We encourage you to call or e-mail anytime you would like to discuss your portfolio or other financial matters.

Sincerely,

DOWLING & YAHNKE WEALTH ADVISORS

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