- U.S. recession risks are rising, and stagflation may be poised for a comeback.
- The Fed’s intent focus on fighting inflation has been negative for equities broadly, in our view; investors may want to consider min vol strategies to stay invested while potentially reducing portfolio risk.
- Given the rise in bond yields year-to-date, short-dated bonds offer ways for investors to potentially generate income and help insulate portfolios from additional shocks.
KEY TAKEAWAYS
WHAT IS STAGFLATION AND WHY ARE PEOPLE TALKING ABOUT IT?
Long before we had celebrity couple names like “Bennifer” we had the term “stagflation”; a mash up of stagnation and inflation popularized in the US in the 1970’s. Stagflation occurs when economic growth is slow and both inflation and unemployment are high.
A strong job market has kept us from entering such an environment, but recession risks are rising as the Federal Reserve has vowed to maintain restrictive monetary policy to rein in inflation — even if it comes with economic pain.
Regardless of the differences between now and the 1970s, we believe investors may want to consider positioning portfolios for a further slowdown in economic growth amid elevated inflation.
The September CPI report showed that year on year inflation continues to run above 6%, almost three times its average in the 20 years before COVID-19.1 While some categories within “goods” inflation have decelerated over the past few months, services inflation, which makes up 57% of CPI,2 remains uncomfortably sticky and likely to remain elevated for some time.
Given the threat of a full-blown recession amid persistently higher inflation, we remain defensive on equities. Investors may consider minimum volatility strategies and high dividend stocks as ways to stay invested, while potentially reducing portfolio risk. We also believe that energy stocks remain attractive and believe energy prices can remain high given the recent production cut announcement from OPEC+ and lack of capital investment in the sector.3
Our highest conviction is in fixed-income allocations, as detailed below. We believe bonds may now offer more ballast against volatile equity positions, something they failed to provide in the first half of 2022. Bonds returning to their historic role as a counterbalance to stocks may be an added boon if we are, in fact, headed for a recession.
RECESSION RISKS ARE ON THE RISE
We don’t believe a U.S. recession is a foregone conclusion, but the odds have greatly increased since late July, when we addressed the question: Is America in a recession? Since that time, growth prospects have sunk in the face of the Fed issuing additional rate increases while reiterating its commitment to combating inflation.
Getting inflation under control will "likely require maintaining a restrictive policy stance for quite some time" even at the cost of “pain to households and businesses,” Fed Chair Jerome Powell warned in a speech at Jackson Hole on August 26.4
In a press conference following the Fed’s September FOMC meeting, Chairman Powell repeated this warning about economic pain and cited “diminishing chances of a soft landing.”⁵
Other FOMC members have similarly made it clear they will tolerate a recession as collateral damage to meeting their goal of driving inflation down.
The Fed’s summary of economic projections in September showed a big downward revision to growth, with the median projection for real GDP at just 0.2% this year and 1.2% next year. The Fed also foresees the unemployment rate hitting 4.4% by end of 2023, up from 3.5% in September, which matched the lowest level in 50 years.6 Our recession indicator highlights that anything above a 4.2% unemployment rate will be a signal that the economy could be heading towards a recession.
BlackRock recession monitor: Recession risks rising
Source: BlackRock, Bloomberg, chart by iShares Investment Strategy. Metrics, rationale, and levels of concern are determined by iShares Investment Strategy research and analytics. Level of concern is generally determined using historical recession levels, on average. As of September 19, 2022.
For illustrative purposes only.
Chart description: Chart showing BlackRock’s recession monitor, which is currently flashing warning signs on three of its five categories, suggesting recession risks are rising but not imminent.
BONDS ARE BACK
A year ago, the interest rate offered on short-term Treasury bonds ranging from 1 month to 1 year to maturity was next to zero.7 For example, one would have to buy a US Treasury bond maturing in 10 years to achieve a yield of 1.5% per annum, and the bond carried the risk of its price falling if interest rates jumped — bond prices typically fall when interest rates rise. If interest rates rose by 1%, that 10-year bond’s price would have fallen by approximately 10%.8
Today, the same investor could achieve a yield of 4% by holding a U.S. Treasury maturing in one year.9 And if interest rates rose by 1%, the price of that Treasury would only fall approximately 1%. In other words, the higher the yield a bond offers, the more of a ‘buffer’ it could have against the impact of rising rates on its price.
Bond yields: What a difference 9 months make
Source: BlackRock and Bloomberg as of 09/30/2022. All yields shown are yields to worst.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Chart description: Bar chart showing the increase in yields for major fixed-income indexes from 12/31/2021 through 09/30/2022.
THREE FIXED-INCOME SECTORS WE LIKE
We believe that front end U.S. government bonds, investment-grade debt and short-dated TIPS look most attractive for this environment.
In our view, if the Fed raises rates above 4% and then pauses for some time, as is currently priced by the market, owning short-dated Treasuries may be beneficial in a portfolio looking to generate income. Over the past year, the yield of 2-year Treasury bonds has risen from 0.28% to over 4%, its highest level since 2007.10
A peak, or terminal, Fed funds rate above 4% combined with projected GDP growth at 1.2% next year is a recipe for stagflation, especially as we believe inflation will remain stubbornly high despite the Fed’s efforts to date. Interestingly, the Fed’s own forecast for Core PCE doesn’t have inflation falling back below 3% till 2024.11 We believe inflation remaining stubbornly higher amid an environment of stable rates can be an excellent time to own front end inflation linked bonds in a portfolio.
Corporate earnings season in the U.S. has proven more resilient than market expectations, as many investment-grade companies have robust balance sheets and fundamentals. With the 1 to 5-year part of the investment grade market yielding over 5.3%, shorter-dated investment grade fixed income appears to us as an attractive source of quality, resilience, diversification, and income.12
CONCLUSION
It’s impossible to know how quickly we actually get to a toxic combination of lower growth, rising unemployment and higher inflation, or how long that lasts. A myriad of factors could cause the Fed to alter the path of monetary policy to a more dovish stance if growth slows meaningfully, or a more hawkish stance if inflation continues to accelerate.
We believe the current macro environment is not supportive of stocks, which is why investors may want to consider min vol strategies to stay invested while potentially reducing risk — and consider using bond ETFs to generate income and reprise their traditional role as portfolio shock absorbers.
