Perspectives on the Market
CWM recently hosted an evening featuring investment strategy experts from our partners at Eaton Vance: Damon Novelli, Executive Director, and Andrew Goodale, Managing Director and Institutional Portfolio Manager. In addition to CWM’s Lead Advisor Brian Lockett, CFP®, and Chief Investment Officer Morgan Arford, Damon and Andrew lent their perspectives on the current financial climate and addressed client’s questions as we rounded out Q2.
Before the speakers began in earnest, guests at the event had fun playing PAWSwalk Bingo, “buying” squares challenging Brian, Morgan, and other members of the CWM team to feats such as exercising in a banana costume, a Macarena dance party and a planking challenge. The event brings us even closer to our $100,000 goal for our PAWS campaign in memory of Linda McCormack.
Brian also reminded guests about CWM’s Extended Savings program, which is an opportunity to maximize the benefits of long-term cash reserves currently held in your bank and/or savings account.
Read on for a brief recap of insights from Morgan, Brian, Damon and Andrew.
Twitter-worthy executive summary: A threat of recession may put downward pressure on stock prices. Falling economic activity, federal government budgetary constraints, and a potential commercial real estate collapse may lead the Fed to cut interest rates, which is historically a good setup for bond assets.
Morgan and Brian kicked the evening off with a market update from a CWM perspective, namely that as we reach the end of Q2, key indicators suggest that recession is on the horizon. Namely:
- Manufacturing is in strong contraction and downtrend, while the service economy is in a downtrend but still expanding.
- Valuations remain elevated and have stagnated in a multi-month sideways range.
- Momentum is mixed and inconsistent, with some strong short-term momentum and some weak mid- to long-term momentum.
The most aggressive Fed rate hike regime since the 1980s has created a strongly negative curve inversion across a swath of maturities. It’s worth noting that these inversions have preceded every recession since the 1970s. One sign that recession may already be here is the rate of large bankruptcies – 70 so far in 2023, which is higher than the 2000 recession and in the same range as the 2020 and 2008 recessions.
Source: Shedlock, M. (April 30, 2023). There are 70 Major Bankruptcies in Just 4 Months This Year. MishTalk.
A big lingering question is whether the housing market will hold up. Sales of existing homes are stagnating, as people who bought in with 3% mortgages are reluctant to sell and double their interest rates (as Brian likes to say people are now married to their mortgages). However, sales of new homes continue to rise.
While interest rates are higher than a few years ago, they are still low historically, and remain low for homeowners who refinanced prior to rates rising. That fact, combined with the remaining momentum from the stimulus, has enabled consumer spending to remain high. It’s unclear if that will last, though – with part of the recent debt ceiling deal involved re-starting student loan payments at the end of August, so many Americans will have another large bill to pay each month.
These student loan payments may be the factor that leads to a “shadow inventory” of investment properties hitting the market as investors sell off vacation rentals that are no longer lucrative thanks to the loss of marginal income that enables luxury spending like leisure travel. Short term rental properties that are reliant on consistent tenancy could suddenly find their business models untenable. That increased supply could pose a great opportunity for those currently renting and thinking of buying.
While residential real estate is holding steady for now, commercial real estate is still on the decline as work from home becomes a way of life for many Americans. Commercial real estate has high vacancy, high borrowing costs, peak levels of refinancing – and the majority of creditors in this space are small community banks. These conditions are leading to tighter lending conditions across the board, conditions which also have a high correlation with recession.
But recession isn’t something to fear – it’s a time for opportunities, such as including more bonds in your portfolio. The key, as always, is to focus on what we can control and make investment decisions mindfully.
Possibilities vs. Probabilities
Damon Novelli, Executive Director for Eaton Vance, part of Morgan Stanley
Damon reminded guests to focus on what’s probable, not just what’s possible. It’s possible that you’ll be struck by lightning the next time you step outside – but is it probable? Keep that mindset as you watch the markets this year. Because if there’s one thing we know for sure, it’s that markets are unpredictable. The consensus among the most prominent financial minds is that there is no consensus.
With probability in mind, it’s a good idea to look at equity markets through three different lenses: volatility, valuations and profit margins.
Markets are less volatile than they have been over the last 10-year average, yet margins for valuation and profit margins are as good as we’ve seen. This is largely due to high earnings among just a few (≤10) companies who successfully passed their COVID-era price increases on to their customers – and who continue to post record profits. As inflation moves from goods to services, these companies won’t be able to price it into their margins as effectively, so we may see earnings drop if this shift occurs.
Considering these earnings are so tightly held among the top 7 to 10 companies on the S&P 500, it’s less accurate to say “markets are up” and more accurate to say “a few companies are doing very well.”
Think of a recession as a slowing – like a car going from 140 mph to 100 mph. The car is still going fast, just not as fast as it was before. Recession is a time to batten down the hatches, but also a time for making smart moves as zombie companies go under and good companies absorb bad.
As we look ahead into the unknown, remember to concentrate on what’s probable, not merely possible.
Looking at fixed income with fresh eyes
Andrew Goodale, Managing Director/Institutional Portfolio Manager for Eaton Vance, part of Morgan Stanley
It’s not often that the fixed income environment garners much attention – for decades, it’s been the low-risk, low-yield portion of the portfolio to protect against volatility. But as we move closer to recession, bond assets can yield more and provide diversification in the face of inflation. In fact, if you don’t have inflation protection already built into your portfolio, now is the time to consider it.
Inflation is slowly improving as the labor market becomes more balanced, but not all inflation is created equal. Headline inflation is slowing down, while core inflation remains sticky. The good news is that the labor market has continued to improve for employers, which should ease pressure on inflation in the service economy.
Meanwhile, credit conditions are set to tighten further after the recent stress in the banking system causes lenders to pull back. A majority of regional banks’ holdings are in commercial real estate, which continues to struggle in the new work-from-home world. Meanwhile, big banks are feeling pressure from regulators to “save the day,” and are growing more cautious in their lending practices.
You don’t need to be in the riskiest part of the bond market to be successful. Investment-grade bonds can be a good choice for conditions like these, with their lower risk of default. In the worst-case scenario, they will be converted to high-yield bonds. On a risk-adjusted basis, you get the best of fixed income generally without as much downside risk.
Finally, looking at returns among various asset classes in recent years, we see a large degree of variation. That makes the case for a diversified portfolio across a range of classes to protect against that variation and maintain a more consistent return.
Thank you for a special night!
It was our pleasure to host our valued clients and insightful guest speakers at this in-person event. These presentations are always available in webinar form for those who don’t wish to travel. Stay updated at www.cwmnw.com/events.
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