Melting Recession Worries

Last week the US Bureau of Economic Analysis released its Q4 2022 Gross Domestic Product (GDP) report. The economy, after two-quarters of contraction in Q1 and Q2 2022, recovered with economic growth in the remaining two quarters of 2022 to end the year on a positive up trend.

The pace of growth for the last two quarters of 2022 increased at pre-pandemic levels, in which the GDP gained momentum in the second half of 2022 and recovered all the declines of the first half to end the year with an overall positive gain.

I could almost, mind you almost, hear the disappointment from the media elite and analysts as their predictions of doom seemed to be melting like the wicked witch of the Wizard of Oz. Almost immediately after Jerome Powell, chairman of the Federal Reserve, announced the beginning of a rate hike policy in March 2022 to slow inflation and prevent another economic crisis, the media, and analysts began a seemingly orchestrated message of woes that the US economy was doomed. Not sure what motivated the messaging or if politics were somehow involved (was there a mid-term election last year?), but the comments were consistent in that the Federal Open Market Committee (FOMC) had incorrectly assessed the state of the economy. They opined that businesses and consumers were teetering on collapse and did not have the financial resources or capabilities to absorb higher costs of debt.

Ironically, there didn’t seem to be any commentary on what would happen if the Federal Reserve didn’t start raising interest rates. Already were signs of a potential economic collapse, with housing prices already soaring due to sub-3 % fixed mortgage rates, governments printing money like drunken sailors, and businesses leveraging growth with low-cost debt. The runaway train of cheap money chasing to view goods prompts inflation not seen since the 1970s simply due to the trillions of government-issued money floating throughout our economy. The Federal Reserve can’t stop the government from printing money and handing it out to almost everyone (I hope you got some); it can raise the cost of new debt in an attempt to slow spending.

So how did it work out? Well, so far, and thankfully, the media and analysts underestimated the resilience of the US economy and specifically small businesses (defined as those with 500 or fewer employees). As a reminder, small businesses represented 99.9% of all businesses in America, despite 80% of small businesses having no employees, representing 46.5% of all new hires in 2022. In other words, 20% of small businesses provide almost the same amount of new job opportunities as ALL other companies, Federal and state government, and non-profits combined. During 2022, the unemployment rate declined, and in January notched down again and to the lowest level since 1969, and more people are working in the history of America. This surely does not feel like a recession.

The flow of paychecks, not government subsidies, is the backbone of sustainable economic growth as inspired employees look for ways to invest or spend their earnings. Jerome Powell and his committee correctly assessed that interest rates were too low, and the economy had the reserves to absorb rising debt costs that were well below historical averages.

However, there were casualties to the rapid rise of the Federal Discount rate from 0% – 0.25% to the current 4.5% to 4.75%. The bond market experienced declines and volatility not seen since the 1970s. Bond prices adjust opposite to interest rates (rates rise and bond prices decline). The aggressive rate hike policy sent bond prices plummeting, with the 20+ Year Treasury ETF (TLT) dropping 32.8% in 2022, matching the decline of the NASDAQ.

The implosion was across all bond markets, from low-rated bonds (AKA “Junk Bonds”), municipal bonds, and even the highest credit-rated corporate bonds. Illustrated below are the 2022 returns of SPDR Bloomberg High Yield Bond ETF (-17.1%), iShares Core US Aggregate Bond ETF (-15.0%), and Bloomberg Municipal Bond ETF (-8.53%). These declines have been unmatched in the past 40 years.

We wrote for years that once interest rates began to rise that bonds would experience declines commensurate to speculative stocks. We removed traditional bond funds from our model portfolio in early 2022 and replaced them with income funds that have hedged against rising interest rates and held high percentage allocation to money market funds. Unfortunately, in the massive bond selloff, even the strategic income funds experienced mild declines but nothing close to that of the Treasury market and corporate bond market experienced.

Other overheated markets also slowed, including mortgage lending, housing, and credit markets. As mentioned earlier, the alternative of the Federal Reserve not raising the rate and combating hyperinflation would, in our opinion, result in greater economic calamity.

After nine consecutive Federal Reserve rate hikes, the economy appears to be doing fine. The next several GDP monthly reports in 2023 will determine how resilient the economy truly is and if additional industries will be negatively impacted. Jerome Powell stated in March 2022 that their target discount rate was 5.00 – 5.25% which would represent one or two more rate hikes. After that, Mr. Powell indicated that the committee would hold rates to determine the results of their increases, which typically take nine to twelve months to be fully assimilated into the economy.  

What Does This Mean to Me?

The evidence, so far, is the fears of a recession in 2023 are melting away. We maintain our favorable view of the economy and stock market. The stability of households with a strong labor market will be the basis for continued economic growth. As we have mentioned in previous updates, the combination of millions of households with sub-4 % fixed mortgages and strong employment will continue to support solid consumer spending. Consumer spending represents 66% of the US GDP, that not surprisingly recovered to positive gains in the second half of 2022. 

Call or email us if you have any questions. We welcome the opportunity to be of service to you.