The Fed and recession risk revisited: What to know

Back in July, we wrote a piece discussing the potential for an upcoming recession in the U.S. A lot has happened since then, and we feel now is a good time to revisit the chances we see a recession in 2023.

Recessions and the Fed

The threat of a potential recession stems from the Federal Reserve's battle against inflation. Inflation results from an imbalance of spending vs. the economy's ability to supply goods and services. The Fed can't do much about the supply side, but it can use interest rates to impact spending by making it more expensive to borrow big-ticket items such as cars, houses, or business equipment. This creates knock-on effects: if people buy fewer cars, the car makers buy fewer parts, they hire fewer people, they buy less advertising, etc. These ripple effects eventually spread throughout the economy. 

Slowing the pace of spending has risks, though. To use our car manufacturer analogy, if auto spending falls too much and the car makers start laying people off, those people spend less on other goods and services, leading to layoffs in different industries. This is how rate hikes can lead directly to a recession. Most economists agree that the Fed directly caused two recessions in the early 1980s and was at least partly to blame for recessions in 1991 and 2001. 

The Fed continues to raise interest rates: But how much is enough?

The most recent Consumer Price Index (CPI) showed that prices rose by 7.7% over the last year, which is unacceptably high for the Fed. In response, Chair Powell frequently stated that the Fed would continue to raise rates "until the job is done." In this case, the "job" is bringing inflation back to its 2% target to maintain "price stability." 

The problem is that the Fed doesn't know exactly how much it needs to ease spending in order to slow inflation. Nor can they easily predict how much each rate increase will impact spending. The only thing they can do is to keep hiking rates until inflation wanes. 

In an August speech, Chair Powell said that "history shows that the employment costs of bringing down inflation are likely to increase with delay." He meant that the longer inflation remains high, the more damage to the economy is necessary to bring it back down. This was the lesson learned in the 1970s and the reason why the Fed engineered the two early-1980's recessions previously mentioned.

Hope for a "softish" landing

Given all this, some slowing of the economy is necessary to get inflation back under control. The question is whether it is a mild slowdown (a "soft landing") or a deeper recession (a "hard landing").

In recent months there have been several signs that the economy is starting to slow. The economy averaged 444,000 new jobs per month in the first half of the year. In the most recent month, only 261,000 were added. 

• Spending at retail stores grew at a 16.4% annualized pace in the first half of 2022 but has only grown at a 4.6% pace since then. 
• Home sales have fallen 27% so far this year. 
• During the most recent earnings season, many companies expect weaker demand in coming quarters.

That's the bad news. The good news is that most measures indicate a slower economy but not one that is contracting. Even more encouraging is that inflation is starting to respond to slower spending. For example, in the most recent CPI report, the price of goods alone declined by 0.4%. And while services inflation remains high, it is being boosted by some factors that are likely temporary. 

We should remain cautious and not draw too big of a conclusion from just one CPI report. However, if inflation is already decelerating with the economy only mildly slowing, that would be a very positive sign. This means the Fed does not have to "damage" the economy further to reach its inflation target. That increases the chance that we can avoid a recession altogether.

How can you protect your portfolio?

We factor in recession risk when making portfolio decisions. However, "protecting" your portfolio from a recession is easier said than done. The stock market generally anticipates a recession well before it happens. Put another way, if a possible recession is in the news, investors have already calculated that risk into the price of stocks. 

To see what we mean, look no further than the poor performance of stocks this year. The price dip is a result of the risk of a possible 2023 recession. If there is a mild recession, stocks might not fall at all.

If the economy does not fall into a recession, stocks could rise substantially. This is the other risk of "protecting" your portfolio by reducing your position in stocks. The period following a bear market tends to produce massive upside returns. Missing these significant market jumps can be harmful to your long-term results.

How Facet’s ETF mix can help

Facet's current ETF mix is designed to provide some downside protection while ensuring that clients also participate in the upside should stocks rebound. We have selected ETFs that own companies with higher profit margins, less volatile profits, and lower debt burdens than the average company.

• • Companies with Higher Profit Margins: Higher profit margins allow companies to charge more for their product compared to their cost than average companies. This is because these companies tend to have fewer competitors and/or a more differentiated product for which customers are willing to pay more. As a result, they tend to be more capable of handling inflation by raising the price of their products. They also may be more resilient in a recession due to their competitive position.

• • Less Volatile Profits: By less volatile profits, we mean companies whose profits don't change as much as other companies yearly. These tend to be businesses that sell products that their customers consistently need, making them less likely to see a downturn in sales when a recession hits.

• • Lower Debt Burdens: Companies with lower debt burdens also spend less of their income on interest payments than the average company. This has two advantages in this environment. The first is that having less debt leaves a company less vulnerable to continually rising interest rates. As debts come due, large firms tend to take out new loans to pay off the old ones. This results in increasingly higher interest costs if rates remain high. But the lower the debt burden, the less this matters. 

Secondly, the more debt a company has, the less flexible it will be in an economic downturn. No matter what, debts must be paid,  and a decline in sales during a recession could leave a company in dire financial condition. Companies with less debt have more cushion to withstand a challenging period.

We believe this is the right way to protect from a recession. These companies should do very well if the economy continues to grow rapidly but may provide some downside protection should we enter a recession. Our investment process involves finding the optimal balance of risks and rewards, which is an excellent example of that process in action.