During Capital Management Corporation’s 58-year history there have been both financially-driven and event-driven recessions. Both types were dominated by economic and geopolitical uncertainty, instability and volatility with little hope of finding light at the end of the tunnel.
In previous cycles, recessions were defined as two or more consecutive quarters of negative economic growth (i.e., declining GDP). Using this definition, the US economy entered a recession on January 1 of this year.
Inflation is enemy #1. The central bank is determined to reduce inflation back down to its 2% target. It will take time to reduce it to The Fed’s target as evident of the 8.3% August inflation figure.
Inflation reduction will be challenged by:
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- Winter’s utility bills will be higher for many both domestic and globally. More uncertainty exists in parts of Europe. Will there be enough natural gas to heat homes? As energy is rationed in Germany, which manufacturing industries will be cut the most?
- Home-owner equivalent rent calculations tend to lag actual experiences. Near record house prices combined with mortgage interest rates doubling this year and apartment rents rising indicate continued housing costs increases.
- Food manufacturers have been locked into contracts to sell their products at a certain price for a specific period of time. As contracts renew at higher prices, consumer prices increase.
- Other commodity prices, such as industrial metals and lumber, peaked months ago. This is a good sign. However, many commodity users have not yet recouped their profit margins and may continue to raise the prices of their goods in upcoming months.
- Various supply contracts contain inflation clauses that guarantee price increases tied to prior year inflation. Inflation experienced this year will trigger material price increases of those contracted goods and services in 2023.
As the Fed fights inflation, then value stocks should be favored over growth. Particularly, worrisome are high P/E technology stocks, pandemic lifestyle beneficiaries, and emerging companies yet to generate positive earnings.
At market inflection points, multi-year leadership tends to change. The 1990’s technology surge ended with a recession and bear market encompassing the Dot.com peak and 9/11 attacks. This was followed by value stocks far outpacing growth stocks. Leadership again changed as the US endured the financial crisis with increased regulation and quantitative easing.
Equity portfolios should favor undervalued securities. Given currently high valuations of many mega-capitalization stocks and growth stocks, equity portfolios should maintain exposure to small and mid-capitalization stocks as well as select undervalued large-cap stocks. In general, dividend payers and dividend growers should be rewarded in this environment. Economic sectors and sub-industries that can benefit from above average inflation and rising interest rates include financial, communication, hotel, processing and logistics providers.
In addition, accounts with bond mandates should maintain bond allocations near the lower-end of those mandates. For example, accounts with a mandate for 10% to 30% fixed income exposure, should currently remain closer to 10% bond exposure with short term maturities to preserve value. Long maturity bonds can still lose value from current levels. Take for example, if the 10-year and 30-year US Treasury bonds yield 3.33% and 3.47% respectively. If interest rates for similar newly issued bonds rise by 1% point over the next year, then the 10 & 30-year bonds will lose 4.8% and 13.0% respectively in market value when including coupons.
Economic and financial market rebounds tend to follow the depths of despair. The first twelve months of positive investment results can provide the highest returns of the next market cycle. However, those first twelve months of investment returns typically start during the recession. By the time the first year of positive investment returns ends, the economy tends to be growing off the absolute bottom and bankruptcy filings are nearing peak levels. Such years are not the best economic times, but they tend to be the most rewarding years for investors. As such, the “buy low and sell high” motto is easier said than done.
As many US listed firms did not even produce free cash flow before the recession, stock selection is imperative. Investors should focus on firms expanding profit margins and regularly generating excess cash. Spending years searching for firms with expanding profit margins and growing, recurring free cash flow, our investment portfolios have attractive long-term traits.
NOTE:
The investment department has forwarded the following request to the CMC board of directors:
In order to effectively manage SMID product portfolios, starting December 31st 2022, CMC will limit SMID product deposits to $5 million per account.