The consensus view from economists entering 2023 was that the U.S. would likely be in a recession by the middle of the year. At that time, the Federal Reserve was pressing its most rapid pace of monetary policy tightening in decades, job growth was slowing, mortgage rates were spiking, the manufacturing sector was stagnating, and stocks were in a bear market. A recession was not an unreasonable forecast.  

Fast forward to the present, and the economy has proven to be much more resilient than many had anticipated. Real GDP has grown at a roughly 2.0% annualized pace over the first half of the year. Despite the stronger than anticipated growth, inflation has also cooled considerably.  Looking forward, the widely followed GDPNow model from the Atlanta Fed is projecting 4.9% annualized growth for the third quarter.

The big debate today is whether the Federal Reserve will be successful in engineering a ‘soft landing.’ The term is frequently used to describe the scenario where inflation is brought under control without the economy tipping into a recession. Many economists now believe a soft landing is possible, while others believe the timing of a recession has simply been pushed back to 2024.

There are said to be “long and variable lags” between the time monetary policy is implemented and when its impact ripples through the economy. Some argue that the lags have simply been longer this time. Certain fiscal policies and historically low interest rates on fixed-rate loans allowed individuals and businesses to shore up their balance sheets coming out of the pandemic. This buffer has thus far cushioned the impact of higher financing costs, but there is evidence the buffers are being depleted.

What is the implication for investors if we are heading towards a recession? Certainly, some of the most volatile episodes in the past have occurred around economic downturns. A review of the historical record might surprise you. The chart below from Dimensional Fund Advisors (DFA) reveals the stock market’s performance for the initial two years following the start of every U.S. recession since the 1920s. Note: The average length of the recessions was just 13 months, while only the one beginning in August 1929 lasted more than two years.

There are a couple of observations that jump out to me:

1. The stock market was positive over the initial two years in 12 of the last 16 recessions.
2. The average return across the initial two-year periods was 8.8%, which is only slightly below the long-term average market return of about 10% per year.
3. The four recessions that did have a negative return two years from the onset were among the most notable in history. These include the two recessions that are collectively referred to as the Great Depression (1929 & 1937), the 2001 recession that coincided with the bursting of the Technology Bubble, and the Financial Crisis that began in 2007.

Source: Dimensional Fund Advisors. In USD. Performance includes reinvestment of dividends and capital gains. Growth of wealth shows the growth of a hypothetical investment of $10,000 in the securities in the Fama/French Total US Market Research Index over the 24 months starting the month after the relevant recession start date. Index data presented in the growth of wealth chart is hypothetical and assumes reinvestment of income and no transaction costs or taxes. Sample includes 16 US recessions as identified by the National Bureau of Economic Research (NBER) from October 1926 to February 2020. NBER defines recessions as starting at the peak of a business cycle. A business cycle is a description of the various stages of economic output.

We frequently write about the notion that the stock market is forward-looking. Stock prices do not wait for the official recession announcement before moving. Instead, they are constantly adjusting to incorporate the likelihood of a recession occurring and how severe it might be if it does. This explains a portion of the stronger than expected performance illustrated in the graph above. In many cases, the market likely anticipated the troubled economic waters ahead and corrected lower in advance.

The implication here is that the onset of a recession is not a reliable signal for investors to make large changes to their investment allocations. In some cases, stock prices may be at or near their lows at the onset, while in others, there could be some volatility for a sustained period. It’s impossible to know in real-time one scenario from the other. Fortunately for investors, you don’t need to know. An appropriately diversified portfolio calibrated to an investor’s personal circumstances can be a great tool in the absence of perfect foresight.  Designed appropriately, it can weather the unpredictable ebb and flow of both the economy and the stock market.

Week in Review

• The Fed will conclude its next meeting on monetary policy today. After keeping its benchmark federal funds rate unchanged at 5.00% to 5.25% in June, the Fed raised the federal funds rate by .25% to a target range of 5.25% to 5.50% in July, the highest range in the past 22 years. The market is currently pricing in the Fed, leaving rates unchanged as a near certainty. Investors will closely monitor the Summary of Economic Projections (SEP) for adjustments to the median estimate for the fed funds rate. The last SEP, published following the June meeting, penciled in one more hike for 2023.  
• Recently published data showed a .6% increase in total U.S. retail sales in August from the prior month, beating the median forecast of .1%. Higher fuel prices were a large contributor to the August figure, while retail sales, excluding gasoline, rose .2%.
• Blackstone and Airbnb joined the S&P 500 on September 18^th as a part of the latest quarterly rebalancing and replaced Lincoln National Corp. Newell Brands Inc. Blackstone is the first of the major alternative asset managers to join the S&P 500.

Hot Reads

Markets

• Fed Debates When to Stop Raising Rates. What to Watch at Wednesday’s Meeting (WSJ)
• Here’s Everything the Fed is Expected to Do Wednesday (CNBC)
• August Wholesale Inflation Rises 0.7%, Hotter Than Expected, But Core Prices in Check (CNBC)

Investing

• Why Housing Prices Are Getting More Expensive (Ben Carlson)
• A Few Things I’m Pretty Sure About (Morgan Housel)
• Fewer Losers, or More Winners? (Howard Marks)                

Other

• How To Get the Best Sleep Of Your Life (Eric Barker)
• The 10 chippiest moments in Ryder Cup History (Golf Digest)
• Ski Resorts Are Giving Up on Snow (Wired)

Markets at a Glance

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Economic Calendar

Source: MarketWatch

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