Holy Dichotomy!

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OK, by a show of hands who believes we are either now in or will be entering a recession in 2023?  I mean this is all anyone is talking about, and this is what every economic prognosticator is calling for, in our observation.  Here's the rub, while logic tells me that recession is imminent, we have contradictory data sets that must be addressed. 

First and foremost, playing for team recession is the housing market. Given we're at relative record pricing highs with dramatically higher mortgage rates than a year ago it's hard to see the bull case. Further compounding the problem, housing units under construction are at 50-year highs.

All these units are coming online as prices are receding. Surely very well capitalized home builders can hold on and hope for a turnaround, but the many more challenged builders will have to generate revenue and may very likely be the price setters heading into 2023.

One of our favorite reads on the health of the economic cycle are leading economic indicators (LEI). “LEI fell for an eighth consecutive month in October suggesting the economy is possibly in a recession,” according to Ataman Ozyildirim Senior Director, Economics, at The Conference Board.  Now maybe you were thinking that eight straight months could perhaps be climactic in the trend.  LEI has just dipped into negative territory on a percentage year-over-year change versus prior recessions that have seen a 10% decline in LEI Y/Y during 2000 as well as COVID, and a 20% Y/Y decline in early 2009.  It appears we have more to go.

Our final player for team recession is the inverted yield curve.  Pictured below is the spread between the 10- and 2-year treasury yields.  It is our understanding that every recession in the US was preceded by such an inversion but not every inversion has led to a recession.  One must look back to early 80’s to find an inversion this severe.  Our interpretation: the bond market believes growth will be slowing in 2023.

Now onto team glass half full.  We are adamant students of economic and business cycles and believe they have an enormous influence on asset prices and sector performance.  Now, if we were close to coming out of a significant downturn, we would look to overweight cyclical sectors like semiconductors and industrials.  We do have some industrial exposure that is more nuanced around sales verticals and cash flow versus a positive inflection in the economy.  We have very little semiconductor exposure because our work shows it’s too early in the cycle to make those investments in size.  Now the reason I am making this point in favor of the glass-half-full team is the performance of the stocks.  One of the ETFs that tracks semiconductors (SMH) is up around 25% from the low in October.  That is a big move from a group that often discounts a recovery before most others, in my opinion.  One of the ETFs that tracks industrials (XLI) is up around 19% since the low in October.  Either these stocks are discounting a recovery that no one is talking about, or they have simply moved too far too fast given still deteriorating fundamentals.  We remain skeptical, however, I will say when you look company by company there are encouraging signs.  Honeywell is a stock we own; this is not an endorsement of an investment.  Honeywell reported a solid third quarter and said they are on the hunt for large acquisitions.  Sounds like a confident management team with reliable visibility to me.

This next data set I find truly amazing.  The Atlanta Fed is forecasting a Q4 2022 GDP print over 4% at this time (insert mind blown emoji).  Wall Street economists are nowhere near 4% as depicted in the bottom half of the chart.  Now, we believe this would have to come on the services side of GDP, after all if America can do one thing really well it’s consume services!  I have witnessed many weak numbers when it comes to goods, whether it be ISM manufacturing or new orders.  The goods side of the equation is weak and getting weaker in our opinion.  There is a downside to what is likely healthy spending on services.  The services components within inflationary readings are still rather robust whereas the goods side of things is in relative retreat when it comes to price.

The third feather in the soft-landing cap would be the Federal Reserve themselves.  Chairman Powell spoke at the Brookings Institute on 11/30/22.  I think rather importantly he echoed a notion expressed by other Fed presidents that the time has come to consider more moderate rate increases.  Further, he made no mention of a terminal Fed Funds Rate far above 5%, one of his colleagues was calling for a range of 5%-7%.  It appears Powell authentically believes he can conclude his course of tightening and not drive the economy into recession.  And that, I believe, was the Dovish tilt.  He seems to have either been sufficiently scared by spreads in fixed income and what they suggest for growth going forward or feels that inflation is moderating at an acceptable rate.  We’ll find out more on 12/14/22. 

The house view is still one of skepticism when it comes to a recession in 2023.  It appears that the leading economic indicators, by our work, are accelerating to the downside.  Further, it is extremely hard to imagine housing not coming under pressure in terms of price and sales volume in 2023 which we believe will be a headwind for consumer spending.  Now, none of this means it can’t be a good year for investment returns in 2023.  We firmly believe that active managers that choose their spots by sector and stocks wisely will outperform in 2023, perhaps considerably.  We will share some of the areas that we find especially compelling in our 2023 outlook newsletter next month.  For our investors and regular readers, our preferences will not be surprising.

Enjoy the holiday season and be on the lookout for another letter from us in two weeks!  We will talk about our views on active investing versus passive in general, and as we enter 2023. 

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Sincerely,

Frank Grinnell

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