By Tim Courtney, Chief Investment Officer
For most of the last 20 years, the U.S. economy has experienced falling inflation and lower interest rates, while maintaining an efficient supply chain and a labor market with good participation. In a nutshell, we had it pretty good. As discussed in a recent commentary though, we’ve since emerged from this greenhouse era for the markets; valuations are being challenged and assets must now grow in nonideal conditions.
Since 2002, the mostly accommodative actions by the Federal Reserve, and by the government through spending, produced longer business cycles and only one recession, which occurred after the Great Financial Crisis (we’ll exclude the COVID shutdown one that lasted one quarter – although we are still feeling the repercussions of both of those recessions). In earlier times, when the Fed wasn’t persistently accommodative, we might expect three or four recessions over two decades.
Recessions are not pleasant but can serve a purpose to stabilize supply and demand, and to reallocate capital and people’s work towards more useful and productive ends. Since the last true recession ended over a decade ago, many companies that lost money or were only marginally profitable were able to survive on accommodative policy and low-cost capital.
We mentioned last week that the current environment is most difficult for these companies. For example, the online brokerage firm Robinhood, which appeared in the marketplace amid very favorable conditions, is now struggling. The company forced the elimination or reduction of trading costs throughout the brokerage industry in a win for investors (these firms now must generate income in a way that is not always obvious to consumers – that may be a future commentary). But Robinhood and many like it are struggling to produce earnings, and markets which cheered the stock one year ago are punishing it today.
Higher rates are forcing some marginal companies into default. Defaults on leveraged loans, which often have adjustable interest rates, reached $6 billion in August, the highest monthly total since October 2020.1 The removal of accommodative policy is having an increasingly negative effect on unprofitable companies, and capital is tending to flow away from them as would happen in a recession.
So recession or not, some of the healthy rebalancing you would typically see in a recession is already occurring. The Fed continues to raise rates and did so again this week with another 75-basis-point hike in an attempt to rein in inflation and other market distortions that have arisen in the last decade.2 They also must deal with their balance sheet and the large amount of money supply growth since 2020. While we think current numbers are strong enough to avoid a recession for now, the odds of a 2023 recession have risen. For investors though, higher bond yields and more reasonable stock valuations are providing some margin for safety as we approach year end. If you have any questions about your portfolio, please contact your Exencial Advisor.
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