- U.S. Manufacturing is now in recession.
- The Yield Curve inverted the most in modern history.
- Weak Retail Sales throughout the holiday season.
- The market has not priced in additional rate hikes.
Our economic updates are written once weekly by nVest Advisors CEO Jeremy Torgerson for the general education of the public, and as a way to provide transparency for our clients and sponsored-plan participants as to how we create and modify our investment models.
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U.S. Manufacturing is now in recession.
The Empire State and Philly Manufacturing Indexes for December were released last week. Both showed continued slowing in manufacturing activity in their regions. Sustained declines in output, combined with worsening new orders for new products and a decline in workers’ hours, all point to a recession reaching the U.S. manufacturing sector in December. Analysts expected a 0.1% decline from November, but the actual figure came in sharply lower.
Additionally, the Conference Board Survey of Leading Economic Indicators (output, new orders, new job listings, new housing permits, etc.) is negative for the 10th straight monthly decline (the longest in decades) and is pointing to a sharp downturn in economic activity in the near-term, signaling that we have either are beginning a recession or are in one already.
What this means to you:
Recessions generally mean reduced economic output and are typically felt broadly across most parts of our economy. You can have output declines that are specific to one sector of the economy (housing, for instance) but a recession is declared when total output in the U.S. declines.
Reduced output sadly means that workers’ hours cannot be sustained at current levels. We would expect to now see a further reduction in the average weekly hours workers put in, followed by hiring freezes, then furloughs, and finally, if new orders for products remain low, layoffs and even factory closures.
The Yield Curve inverted the most in modern history.
The Yield Curve is simply a graph showing the different investment returns investors can get by purchasing and holding Treasury bonds until they mature. All interest rates in the country, whether they are for a corporate bond or a mortgage for your home, closely follow these prime rates.
Normally (and perfectly logically), the longer someone is asking to borrow your money, the more interest you should receive. So normally, a 30-year treasury bond should pay more than a 20-year, 10-year, or 5-year bond, and if someone borrows money for just a few days, the interest payment should be minimal.
In normal conditions then, if you plotted a graph of the interest you’d get loaning for your money to the government, the longer you lent them money, the more interest you’d receive. This perfectly logical arrangement normally produces a yield curve graph that looks like the blue line below.
Things can go awry, however, and this can cause yield curves to go flat (the green line), or even invert (the red line). An inverted yield curve indicates that the exact opposite of normal conditions is happening with government debt – investors can get more return if they lend their money for very short-term debts than they can if they lend for longer periods of time.
An inverted yield curve is a significant financial event when it happens. It has, with almost perfect accuracy, predicted a coming economic recession and a stock market decline of at least 10% (though more normally 20% or more). In the United States, our Yield Curve inverted last spring and has been inverted for almost a year. Our current Yield Curve is one of the most substantial inversions in history:
What this means to you:
As our Federal Reserve Bank takes action to fight inflation, they’ve raised interest rates at the fastest rate in history. They do this by raising what is called the Fed Funds Rate – the rate that banks can borrow money overnight from the country’s central bank. In healthy economies, this change in rates would rapidly affect the rest of the curve, shifting all of it in the same direction as the change in the Fed Funds rate. However, in this case, the rate hikes at the short end of the graph spiked the yield on those short-term loans significantly, but the rest of the yield curve hasn’t kept up with it.
It’s the most substantial yield curve inversion since 1981 when the economy was pushed into a deep recession. This is what investors are starting to take in, and a large part of why the U.S. stock markets declined last week.
Weak retail sales throughout the 2022 holiday shopping season.
Retail sales were down in December, signaling a weak holiday shopping season and likely, lower earnings for company stocks in the retail sector this quarter. Remember when looking at these graphs, these sales figures include the increases in prices due to inflation over the last two years. In-store sales declined 3%, and online orders declined 5%. These were substantially lower than in December of 2021 and continue the declines seen very consistently throughout 2022.
What this means for you:
Retail sales are one of the primary places we can see how the economy is impacting the consumer. This matters so much because over 70% of our entire economic output (called our GDP or gross domestic product) is you and me spending our paychecks. It appears that consumers are now very “strapped” financially, and did not even increase spending during the traditional gift-giving season when retailers always report the majority of their annual sales. This is a very strong signal of impending recession and further slowing of factory output and workers’ hours.
Investors are not pricing in additional rate hikes.
One of the reasons you see these wild swings in the stock markets each day right now is that investors are digesting different economic news and corporate earnings reports as they come in, and are trying to place bets for the coming months based on their extrapolation of that information. Often, people focused only on stock prices and current reports suffer from a combination of what is called recency bias and confirmation bias. These are two very common behavioral mistakes investors make with money. Our money management principles seek to factor out these common human biases (and there are others, like our preference for round numbers, meaning people place more importance on the S&P reaching 4,000 than it will on the index reaching 3,999).
Recency bias is the notion that the newest news about something is somehow more important than older news or a continuing trend. That’s why the markets moving up today, even if it dissolves tomorrow, is such a headline. Most financial and economic indicators wobble up and down on their way to a trend. If you focus only on the most recent number, and don’t take the overall trend into account, you can make a significant investing mistake by “seeing the trees, but not the forest”.
Confirmation bias is universal in people. It states that what we believe in, we also believe to be absolutely true. So we often go seeking other opinions or data that confirm what we believe already to be true, and quickly discount any evidence or opinion that challenges our worldview. (Confirmation bias in politics, for instance, will have us wanting to vilify a politician on the “other side” who does something unethical, while looking to find ways to excuse the same behavior in “our guy”. It’s one reason out of many that nVest Advisors is completely apolitical in the work we do for you- your IRA doesn’t care who the President is or who you voted for).
Another bias that we see a lot of in investing is called herd mentality. It’s a survival instinct. If the majority of people are doing something, we tend to do it, too, to protect our interests. You’ll see this in a flock of birds or a school of fish evading a predator, and we do the same thing. If you look and point at something, other people will look to see what you’re pointing at.
Combine these three biases alone and you have the daily struggle between bulls (optimists) and bears (pessimists) on Wall Street.
We believe the economic indicators continue to point to a steep and prolonged recession, longer and harsher than many of our peers believe. We believe in taking the members of the Federal Reserve Board at their word about what they will do and which indicators are providing them guidance. Right now, the Fed says they are singularly focused on reducing inflation back to its 2% target rate. Doing so will mean deliberately weakening the economy, and especially the job market, until the upward pressure on wages and prices is definitely reversed.
However, there are a lot of contrarians in the market, second-guessing the Fed’s resolve. And because of herd mentality, stock prices tend to follow the most recent trend (recency bias), drawing the bulls and bears into competing camps (confirmation bias). Right now, and for the last six months or so, the bulls’ view has been the prevailing one. It’s not one we agree with based only on the data and how recessions historically start and play out.
For example, as financial news comes in that shows the economy is deteriorating, investors are betting that the Federal Reserve will be forced to lower interest rates faster than they are currently projecting. The purple line was where Wall Street thought the trajectory of the Fed Funds rate would go over the coming months. The blue line is where they are betting it will be now.
Are they right? No one knows, but the Fed is pretty transparent about their thinking. For example, the Fed’s board members create what they call a “dot plot” of where each voting member of the Fed believes interest rates will be by the end of each year. One dot equals one vote of the Fed’s board:
It makes sense to follow their guidance in making interest rate expectations, doesn’t it? But investors have placed yields on the purple line, not the red line (the median of all of the votes). The bottom line is the market is betting the Fed “flinches” early and lowers rates significantly below where the Fed itself says rates will likely be.
Is it wise to second-guess the Fed? So far in this economic cycle, no. The Fed was slow to respond to rising inflation in 2020 and 2021, believing most of it was related to supply problems from Covid shutdowns, not to the massive money dumps the governments of the world did to keep their economies moving during those (our opinion: completely unnecessary) shutdowns. However, since making their turn in early 2022 and announcing their resolve to bring inflation back down to the target rate of 2% per year, they have done everything they said they would do. There have been no surprises by the Fed, and its members (especially Fed Chairman Jerome Powell), have been extraordinarily transparent as to their objectives and their strategies. We believe it is foolish to place investment positions months to years ahead of time based only on the notion that the Fed will panic and pivot to rate reductions earlier than they themselves are projecting.
What this means for you:
Right now, the investment markets have not fully priced in either a recession or prolonged higher interest rates. This means, if the Fed is to be believed and the economy does enter recession as nearly all of the leading data indicates, there is still substantial downside risk in the investment markets. You must have your portfolios properly positioned for an additional 20-30% declines in stock prices in the coming weeks and months, in our opinion. Our Macroeconomic investment principles made these changes a year ago for most of our clients, and are revised every 4-6 weeks as new data comes to us. If your investment manager is not doing this work, it’s urgent that you seek out a second opinion. Most account losses will eventually come back, but it make take 4-6 years or longer.
We firmly believe the United States and much of the rest of the developed world will endure a recession in 2023. No one knows exactly when a recession will be declared, but we firmly believe most of the larger economies of the world are right at the door of one now. Recessions can take years to recover from, which is why we believe it is vitally important to get your family and business finances ready to weather through such a storm.
Whether you are our client or not, you need to consider the broader economy (and much less so the daily market fluctuations) when making investment decisions. The economy is telling us clearly what is coming, and you need to have your investment accounts prepared before that happens.
Use these economic reports, and those of others working in this space, to prepare. You can not only avoid much of the pain that is coming, but you might actually profit from it, if your investments are properly positioned, and you’ve done what you can to shore up your business’ and family’s financial situation. If you need help with this, nVest Advisors has amazingly affordable personal financial planning and fiduciary investment management services to help you.
This is what we do for a living, and we’re very happy to partner with you on that endeavor.
Reach out to us for a totally free financial and portfolio checkup today if you’re concerned about where your finances sit for the coming few years, particularly if you are at or approaching retirement age. We’re delighted to offer you our thoughts. You can schedule that time with us below:
Watching This Week:
- Thursday, we will get updated news on the current inflation rate in the U.S.
- Friday, we will learn the new consumer sentiment numbers from the University of Michigan.