Financial planning forecast: Cloudy with a chance of recession

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by Cara Esser, CFA, Managing Director, Research & Portfolio Management
Mesirow Retirement Advisory Services

Predicting the future is hard and “experts” are often wrong. For evidence, look no further than the last 12 months. A year ago, inflation was transitory, the pandemic was waning, and interest rates were expected to remain near zero well into 2023. Then the pandemic reasserted itself, the shortest recession in US history was followed by the fastest recovery in almost 40 years, inflation hit its highest rate since the 1980s, and a war erupted at NATO’s doorstep.

Sunscreen and an umbrella

Clearly, making long term forecasts based on short term indicators is a tricky and often counter-productive pursuit. That said, investors and their advisors must prepare for the future. And given the future’s unpredictability, it’s wise to be ready if that forecast doesn’t pan out. Call it the “sunscreen and an umbrella” approach.

To that end, let’s look at some influential economic and market indicators and see what they’re telling us about the likelihood for higher rates, rising inflation levels and future economic growth.

Are we at peak inflation?

Top line inflation reached 8.5% in March, the highest level since 1981. Inflationary pressures are broadening out, but some formerly “hot” areas are cooling off.

Chart 1: INFLATION

Data is monthly change from April 2022 to May 2022; Year over Year from May 2021 to May 2022. Source: Bureau of Labor Statistics. Past performance is not indicative of future results.

Wage growth is evident across the board. Indicators suggest that will continue, at least for the near term. The labor force participation rate remains below pre-pandemic levels and unemployment rates are at all-time lows. Demographics and low immigration point to a reduced labor supply.

Chart 2: Annual wage growth

Data as of 3.31.2022. Source: Federal Reserve Bank of Atlanta. Past performance is not indicative of future results.

Currently, supply chains remain snarled, demand hasn’t slowed despite higher prices and wage increases are tough to reverse. That would suggest inflation will be well above the Fed’s target 3% rate for an extended period. However, the Fed is committed to controlling inflation through higher rates, supply chain issues will be worked out and energy prices are already relenting. Therefore, it’s difficult to see how inflation will move higher from current levels.

Will the Fed manage a soft landing or overshoot the runway?

The Fed has abruptly shifted its policy in the last six months. As recently as mid-December of 2021, they anticipated near zero rates through 2022. They now expect to reach 2.5-3% by the end of this year, though revisions higher aren’t out of the question.

Chart 3: Federal reserve median predication of fed funds rate

Data as of 3.31.2022. Source: Federal Reserve. Past performance is not indicative of future results.

The worry is that the Fed will hike us into a recession. Over the last 80 years, the Fed has never lowered inflation by this much without causing a recession. Fed Chairman Jerome Powell said he’s willing to precipitate a recession if that’s what it takes to tame inflation.

His job is made more difficult by several factors, many of which the Fed can’t control: the war in Ukraine, factory shutdowns in China over COVID fears, supply/ demand imbalances, and low labor force participation rates among them.

Using short-term rates to engineer a “soft landing” is a tricky business. But the good news is that this rate increase was prompted by unique, exogenous events – a global pandemic and a war in Europe – rather than the bursting of an asset bubble or an implosion of the financial markets. Even if we do experience a recession, capital markets and global economies appear fundamentally healthy and should rebound relatively quickly when uncertainties are removed.

What is the housing market telling us?

The housing market is a major indicator of economic health and consumer confidence, and rising interest rates have a huge impact on it. After falling to historic lows, 30-year mortgage rates topped 5% in the first quarter and are still ticking up.

The question is, will higher mortgage rates significantly dampen the housing market? Right now, it seems unlikely. Home prices continue to rise to record levels, though sales of previously owned homes are trending down. The housing shortage in the US is severe—some estimates put it at 3 million homes, with housing inventory in early 2022 dropping to the lowest level since 1999.

Chart 4: 30 Year mortgage rates

Source: Freddie Mac, National Association of Realtors. Past performance is not indicative of future results.

Consumers gonna consume

At the moment, consumers can’t make up their minds. Their confidence never fully recovered from the 2020 COVID-induced recession and fell to record lows recently. Only one time in the history of the survey has the US Consumer Sentiment Index been this low without a recession. About one third of respondents expect their financial position to worsen in the year ahead, the highest level ever recorded.

Chart 5: Index of consumer expectations

Source: University of Michigan. Past performance is not indicative of future results.

Yet despite low consumer confidence and inflation reducing real (adjusted for inflation) disposable personal income, American consumers are still consuming. Credit card spending increased by more than 20% in the first quarter. According to OpenTable, restaurants are serving more in-person diners compared to pre-pandemic levels. The travel industry is seeing a resurgence in demand and consumers are paying high prices for their summer travel plans.

Chart 6: Real Disposable income and consumption

Data as of 3.31.2022. Source: US Bureau of Economic Analysis. Past performance is not indicative of future results.

So, while consumers are saying one thing, they’re doing another. We expect to see some softening in consumer demand as inflation continues to bite, but high levels of consumption remain likely for some time.

GDP growth: Cooling but still strong

Estimates for US GDP growth in 2022 and beyond have been slowly coming down but remain quite strong. Back in October 2021, the World Bank estimated US GDP would be 5% in 2022. It has since lowered its estimate to 3.7%. For context, historical US GDP growth is around 3%.

Source: World Bank. Past performance is not indicative of future results.

What the stock market hates most

Contrary to popular belief, economic downturns aren’t what the stock market hates most. At least in a recession, there are clear winners and losers. What the market hates most is uncertainty. Unfortunately, rising rates, persistent inflation, and the war in Ukraine have created lots of it.

As you might expect, stocks priced for optimism have borne the brunt of the downturn, as evidenced by the performance of growth stocks, particularly tech stocks.

Data as of 6.15.2022. Source: Morningstar Direct. Past performance is not indicative of future results.

However, once the economic picture becomes clearer and uncertainty is removed, investors will place their bets and stocks should rally. The sectors poised to rebound the most are open to debate. But for stock investors who have a time horizon appropriate for the asset class, patience will likely be rewarded.

I’m just a poor bond, nobody loves me

The multi-decade bull market in bonds ended in very dramatic fashion earlier this year. During the first quarter, the Bloomberg US Aggregate Index lost nearly 6%, the worst quarter in more than 40 years. Investors who expected bonds to mitigate stock market losses have been disappointed.

Chart 7: Bloomberg US Aggregate Index Return

Data as of 3.31.2022. Source: Morningstar Direct, Wall Street Journal. Past performance is not indicative of future results.

There’s no question that high inflation and rising interest rates have historically taken a toll on bonds. But that doesn’t mean the asset class has lost its appeal. In fact, the historically negative correlation between stocks and bonds is showing signs of life again. While negative returns on fixed income assets are never welcome, higher yields mean better income opportunities going forward. Again, the key is patience and investing in bonds appropriate for your goals and time horizon.

Do investors need sunscreen or an umbrella?

A survey by The Wall Street Journal showed the average economist put the chance of a recession this year at 28%, up from 13% last year. That said, while it’s unlikely the Fed will get the “soft landing” they’d like, even a bumpy landing doesn’t mean we’re headed for a 2008-like recession:

  • Underlying economic data remains quite strong
  • Higher interest rates are good news for fixed income investors, despite the recent tumult in the bond market
  • The stock market is not the economy

While never an enjoyable experience, volatility like we experienced in early 2022 is a reminder that conditions change. The best way to handle it is to be prepared. Consult with your financial advisor to make sure your portfolio remains aligned to your goals and your time horizons. Historically, bull markets last a lot longer and are more potent than bear markets. So, sunscreen is usually in order. But have that umbrella handy just in case.

 

Bloomberg US Aggregate Bond- measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
MSCI ACWI ex US- measures the performance of non-U.S. stocks from several developed markets and many emerging markets.
MSCI Emerging Markets- measures the performance of large and mid-cap stocks across emerging markets countries.
Nasdaq Composite - measures the performance of all issues listed in the Nasdaq Stock Market.
Russell 1000® Growth- measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to book ratios and higher forecasted growth values.
Russell 2000®- measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
Standard & Poor's 500- market-capitalization-weighted index that measures the performance of the 500 largest U.S. publicly traded companies.


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Mesirow refers to Mesirow Financial Holdings, Inc. and its divisions, subsidiaries and affiliates. The Mesirow name and logo are registered service marks of Mesirow Financial Holdings, Inc. ©2022, Mesirow Financial Holdings, Inc. All rights reserved. Any opinions expressed are subject to change without notice. Past performance is not indicative of future results. Advisory Fees are described in Mesirow Financial Investment Management, Inc.’s Form ADV Part 2A. Advisory services offered through Mesirow Financial Investment Management, Inc. an SEC registered investment advisor. Securities offered by Mesirow Financial, Inc. member FINRA and SIPC.