March 2023

The Rolling Recession

Christopher P. Lorenz

If you were lucky enough to spend the past three months on a beach in the Caribbean or ski lodge in the Rockies and just opened your quarterly investment statement for the first time in a while you will be relieved to see positive returns so far this year. For the rest of us who have been watching the market and listening to the nightly news the constant bombardment of negative commentary around the macro economy, inflation and regional banks, the past three months haas been stressful. The positive returns posted by the S & P 500 and Nasdaq Composite have been hard earned gains and surprising to many. 

The economic discussion for the past 18 months has been dominated by a looming recession caused by a drop in consumer spending and corporate earnings. Unfortunately for the doomsayers, consumer spending and corporate earnings have held up well. As each quarter passes the recession gets pushed out a few quarters. The logic from those calling for a recession makes sense. The Federal Reserve raised interest rates dramatically last year and that will reduce consumer demand and economic activity but we still don’t know when, and by how much. 

Earnings for the S & P 500 were down 10% last year, which is understandable since the previous two years were very strong, but we have yet to see recession level contraction. There are many economic indicators that are flashing red, which could indicate we are closer to that long-predicted recession. Also adding to the concern is that interest rates hikes take over 12 months to impact the broad economy.  While it might turn out that we are on the precipice of recession, the first quarter of 2023 turned out ok as GDP, employment and corporate earnings grew nicely. Once again, the predictors will need to push out the start of the recession. 

Even though our economy is resilient, and employment remains strong, the Federal Reserve will beat inflation by slowing down the economy with interest rate hikes or in its own words, “by breaking something”, or both. The recent collapse of Silicon Valley Bank reflects the stress created by rapidly moving interest rates and reflects something “breaking”. With that said the banking entire system is not broken because it isn’t a monolith. Our banks are unique in several ways ranging from size, to region, business sector and the type of customers they serve so they all have different market conditions to consider. The one thing that impacts them all and makes them similar is that their businesses are built around interest rates. Banks borrow at one interest rate they lend at another. Additionally, banks need to hold collateral for the bank deposits they take in and they buy US Treasuries to hold as collateral. By raising interest rates dramatically, the Federal Reserve has increased the costs for banks to borrow and it also made their collateral less valuable. SVB had a very unique regional and business customer profile, and their deposits were highly concentrated in small number of customers that had enormous deposits, which we easy to move. Their unique customers, and the bank’s poor management made it overly sensitive to higher rates and resulted in the bank’s shareholders losing all of their money. The stress created by interest rates hikes that crushed SVB is affecting all banks, but most regional banks and the large ones, are in much better shape and handling the stress well.   

The banking stress will result in slower business activity and add another headwind for our economy, further testing its resilience. Banks have already been tightening lending standards, which may make the recent bank stress less impactful since tightening was already underway, but it will reduce economic activity further.  There is always a recession in the future because we have a dynamic economy that speeds up and slows down and that’s good because it weeds out poorly run companies and creates space for other companies to flourish. For investors it’s a chance to buy high quality companies at a discount and doesn’t permanently impede appreciation in the long run. So, the hard question isn’t whether we will have a recession, it’s “when”? 

I see one of two scenarios playing out. We will either have a technical recession in the next few quarters or we will continue to experience a “rolling recession. We have already been experiencing a rolling recession that has impacted different business sectors at different times but haven’t lined up at the same time to create a technical recession. The economy experienced two consecutive quarters of negative economic growth in early 2022, which wasn’t considered a technical recession because employment remained strong. For example, housing had a rough year last year as higher interest put buyers on hold. The auto industry was severely damaged by supply chain issues in 2021 and early 2022 but are now doing well because supply chains have improved. There are other business sectors that experienced recessionary conditions that are now improving. Inversely, there are some industries, like banking, that are now facing recessionary pressures. 

The lasting impact from COVID on the economy are the unique crosscurrents, some that show recession and some, like employment, that point to a strong economy. Regardless of the crosscurrents, the fact is that we have very low unemployment rates and when Americans have jobs, they spend. It will be very difficult to notch a technical recession with strong employment like we have and trying to predict a recession is extremely hard. 

The macro-economy isn’t a great predictor for stock returns and that is why we don’t focus on the macro economy. Instead, we invest in individual companies and focus on how they are performing in all types of conditions, recession, or boom times. Our companies are doing well, and have yet to make dire warnings about a recession but also remain cautious due to the unpredictable nature of the impact from the rate hikes. 

My concern has shifted from worrying about inflation to worrying about how impactful the rate hikes be on the economy and corporate earnings. S & P 500 earnings fell 10% last year, which brought stock prices down 30% at the lows last year. Earnings estimates for 2023 have come down significantly already but estimates vary wildly depending on the dept of a recession. I believe our portfolio companies are well positioned for a recession if it occurs because it has been a concern for the past year. If a sailor sees a hurricane two weeks away, there is plenty of time to alter course and prepare. One pundit said this would be the most widely anticipated recession of all time. 

Like the sailor preparing for the storm, our portfolios are prepared. We have higher than normal cash and bond positions, which we will use to take advantage of a recession driven pullback. For the first time in a while investor are being paid to wait since bond yields are very attractive. We have been buying two-year treasuries yielding over 4% so we are getting paid to wait for the skies to clear. 

Whether we have a technical recession or not isn’t that important, there are numerous headwinds for the economy that we need to digest. Corporate America is adapting and has been preparing.  Growth stocks got crushed last year but are leading this year. This means that the “rolling recession” I have seen is showing up in stock leadership. We remained invested in growth stocks last year and are being rewarded for that now. Thus, staying on the course and remaining diversified will allow us to benefit regardless of where the leadership comes from. Recession or not there are headwinds we need to subside and it is my belief that we can emerge from this period and build new momentum for stock prices by the end of the year.