August Market Update: Why Are Stocks Up In the Face of a Recession?

Wealthy Behavior: August Market Update: Why Are Stocks Up In the Face of a Recession?
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00:00:10 – 00:05:06
Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial. The podcast that digs into topics strategies and behaviors that help busy successful people build and protect their personal wealth. I’m your host, Sammy Azzouz president of Heritage Financial, a Boston based wealth management firm working with business owners, executives and retirees for more than 25 years. Now, let’s talk about the wealthy behaviors that are key to a rich life.

Welcome to another investment edition of the Wealthy Behavior podcast where I talk to our Chief Investment Officer, Bob Weisse, about what’s going on in the markets and the investment universe right now. Bob and I have been having these conversations at the beginning of every month for the last few months and will continue to do so. Please look for them wherever you get your podcasts. So Bob, our last episode came out on July 1st and the title of it was, “It’s Different This Time. It’s Actually Not As Bad”, and you and I shared reasons for optimism about this market. Why we didn’t think this bear would be as bad as the last three, and even that we were positive about things like bonds. And I guess Wall Street and investors should send you a thank you note, Bob, because the markets had quite a July. I think it was the best month in over two years. Yeah, that’s right, Sammy. July was interesting, global stocks were up about 7% and bonds even had a total return of about 2.5% so some price appreciation in bonds as yields fell, which is interesting when you think about July. What happened in July? Inflation numbers came out high, people were still concerned about inflation, the fed raised rates, but yields fell. So I think that’s just kind of hits to one of the points we were talking about with a lot of this stuff being priced into the market. So that’s the data in terms of the strong rebound for markets, U.S. large caps did well, small caps did well, sounds like international markets did well, as did bonds. You started to touch on some of the reasons or some of what you saw, but basically what happened? What drove this? Yeah, what we think is happening is the market is shifting from concerns about inflation to concerns about an economic slowdown, i.e., a recession. And those are different environments. The inflationary environment is one of high bond yields rising bond yields, which is quite a headwind and a recession is more the flight to quality. People buy bonds, yields go down, it’s hunker down on quality assets. So they’re different dynamics and we’re starting to see the pendulum shift a little bit from inflation being number one concern to an economic slowdown and a recession being the top concern. And that impacts both the stock and the bond markets? Yeah, the great irony of it is I say that and people are probably cringing ewe, that’s not good. And yet that’s why stocks and bonds made money in July. So you have to unpack that a little bit and say, wait, why is that? And just stepping back, bond yields going down, when yields go down, prices go up, so that’s math. You make money in bonds in that environment. And higher bond yields have been a headwind for stocks. As an asset allocator, every day we have to choose, it’s not this simple, but do you want to buy stocks or bonds? And when bond yields are higher, stocks- all else equal-are less attractive. So bond yields are at 4, 5, 6, 7%, stocks are less attractive than if bond yields are at 2 or 3%. So seeing bond yields fall can be a good thing for stocks as well. So we had a theme in the last couple of podcasts that we did talking about things being priced in or were things being priced in or not. Was July a function of some things that the market was worried about were fully priced in and now it was time to look forward? I think definitely on the interest rate front, we’ve been hearing for a while and answering questions like, “Well, the fed’s raising rates should we get out of bonds?” And it’s no it’s priced in, its price in. And then you know they kept doing that and raising rates more than anyone was expecting. But this month, that was the case. Or in July, that was the case. They raised rates 75 basis points, as expected, and rates fell so the market was totally prepared for that. So where does that leave us now? I joked earlier about our podcast turning the market around, which obviously it didn’t, but it’d be great if it could. We don’t have a crystal ball, and we don’t manage money thinking that we do, but what are you seeing in the data and what are markets telling us right now about where we might be headed? Yeah, so it goes to that point I made a couple of minutes ago about the pendulum shifting from panic about inflation to a recession. And I do think that’s the appropriate perspective. Just stepping back when you think about what’s going on and the fed is in the center, but the fed and their credibility is paramount.

00:05:07 – 00:10:00
When you look at the U.S. dollar Fiat currency, what’s behind it used to be gold the last 50 years, now it’s nothing. And when foreigners put their money in U.S. dollars, when U.S. investors have their savings in dollars, there’s trust that inflation will not run away and erode the value of that currency and the fed is the one that stands behind that. They’re kind of the guardians of preserving the value of the dollar and they take their credibility very seriously. You know what’s interesting is if you go back just to 2020, they said that they want the average rate of inflation to be 2%, not the current rate to change the language slightly, which meant they were going to push up inflation just a little bit to prove to the markets that they could control inflation so precisely because they wanted their credibility. They put a little gasoline on the fire to spark it to get average inflation at 2% so they could say, see we can do it. And then whoops. Now we’re in this mess with inflation running around 9% and it’s their fault. And when it’s all about them have credibility and they made this mistake, they’re going to come out guns blazing and do what it takes to get inflation back down to 2%. That is job number one for them. And what will that do to the economy? More likely than that, it’ll put us into recession. I just think that’s an important backdrop to understand. As opposed to persistent inflation, that we will never be able to get rid of while maintaining a good economy, I think the fed’s going to focus on inflation number one. And that will slow down economic activity. So when you talked about the fed kind of triggering 9%, are you paraphrasing market participants and kind of simplifying the argument or do you put a lot of this on the fed over the last couple of years where we are with inflation today? Oh, no, I definitely put a lot of it on the fed. I mean, the housing market has been out of control. It’s been so hot and interest rates were near zero going into this year. And they were buying mortgage backed securities to pushing down the prices of mortgages. So they were adding stimulus to a very hot housing market, as one example. Job market was strong, so they were just adding a lot of stimulus pretty late in the game. So while inflation was ticking up and then just using the word transitory, I bet they wish they never used it. But the data was showing that inflation is there. Data was showing the economy strong and they were dismissive of it. Oh, it’s transitory. Don’t worry about it. And I think it’s fair to say they were wrong on that. We’re all wrong with things at times so I don’t want to stand here and feel like I’m the one who’s always right. But they missed the boat and they have some catching up to do. So you said more likely than not that we will go into a recession. Why do you say that? And, you know, maybe a connected question to it is, can you have a recession, and there’s been some debates recently about what defines a recession and who determines it, but can you have one without job data getting or job numbers getting a lot worse? No, I don’t think you can. I think for a recession to happen, one of the key measures is employment. And unemployment will have to tick up. Yesterday, just watching CNBC late in the day and watching some companies come out with earnings. I think this gives you a bit of a snapshot of what’s going on. Starbucks was fine. Starbucks had good earnings and you think about a company that is selling coffee and people are still buying coffee, economy is still good. Robinhood, a FinTech brokerage firm, is laying off 23% of their workforce. They lost $300 million for the quarter average daily users down about 33%. So you’re looking on one hand at an establish blue chip company continuing to make money but that’s just part of the economy. And then one of these companies that’s more on the fringe, nonprofitable tech, and that’s the area that’s deflating and that trickles through to the economy. So laying off 23% of their workforce and just seeing things like that that are going to continue to unfold we’re starting to see that reflected in the jobs data that came out yesterday. Yeah, what was the data you shared with me recently, Bob? Yeah, yesterday was jolt so job openings. So on Friday, this coming Friday, it’s the unemployment rate, but yesterday it was job openings so just employers looking to hire people. And it went down so there are fewer job openings just to put it very simply. And the direction with all these things matters, it’s not just the level, but the change. Like, are we going up? Are we going down? And job openings have been increasing. Like you just drive around and it’s everywhere from McDonald’s to you name it. They’re hiring.

00:10:00 – 00:15:02
And that’s changing. I think the labor market is just starting to tighten, but it does have a ways to go. So, you know, you look at that and you talk about soft landing, which is no recession, you know, hard landing, which is a recession, shallow recession, mild recession, longer recession. Does it matter, ultimately, you know, what this ends up being categorized as or can we all just agree that basically there needs to be a slowdown of some sort. There is going to be a slowdown of some sort to get inflation under control and what it ultimately ends up being called or categorized as is less important. I generally agree with you, we just don’t want it to be a 2008 recession and I don’t think it will be. But you can’t say that’s not in the cards at all. So I think they should be able to get us back in a good place, get inflation down without really crashing the economy and taking markets down 50%. It should be a mild recession, a lower case R recession and all those things you’re saying. So hopefully that is as bad as it gets and then investors will do just fine from here if you have a time horizon that that’s, you know, 3, 5, 10 years. So from that standpoint, just being a long-term investor, I wouldn’t get all worked up over discussions like this, getting in the weeds of the technicalities of a recession. What should investors be looking for right now? It’s a little bit, I don’t know, maybe paradoxical to think that, you know, signs of a recession or signs of a slowdown could be positive news for stocks because it will lead to inflation coming under control. Like what’s considered good news, what’s considered bad news, what does the market want to see with the economy and the inflation numbers? That’s a great question. That gets back to July. A recession becomes more likely so stocks go up… So the old adage bad news is good news. I do think everyone wants to see inflation slow down. So good news would be first and foremost, like getting a good CPI print and seeing that come down, seeing the labor market cool off, but you don’t want it to slow down too much. You don’t want a terrible unemployment number. So that’s a tricky one. But just seeing inflation slow, but that’s the good news. The other factors, you can look at them both ways from an investing standpoint though. I think it’s just important to recognize where we are. And that there’s been a lot of price changes in markets and the negative direction over this year. So a lot of this is priced in and as far as what our investors to do at this point, and then it’s just time to continue to invest, rebalance, stay the course, and not get caught up in this. What specifically on the rebalancing front should they be looking at? Both stocks and bonds. We’re now getting about a 4% yield on investment grade bonds, that’s pretty good. So a financial plan in most cases might need 5, 6, 7% if your bonds can get you 4%, that’s solid. So putting money into bonds with yields at that level is good. And then stocks are more attractive. Both the U.S. markets down, but then also overseas. U.S. market was above average valuations. Foreign markets were about average going into this year. And now that they have sold off, they’re pretty cheap. So it’s really buying stocks, buying bonds, and heritage, what we’re doing is we’re selling some of the investments that have made money for our clients this year. So that’s really inflation sensitive assets like real assets and some private credit where we’ve made money. So selling what’s worked to buy what’s down. And you’ve also shared with me that municipal bonds are more attractive right now, which hasn’t always been the case over the last few years, why is that and what are you looking at when you say something like that? Yeah, municipal bonds are interesting. The market is participated in by retail investors. So individual investors, meaning you do not have large sovereign wealth funds in there, institutions so that the depth is not there. So prices can move a little more than they should you could say at times. And retail investors are also known for being a little emotional, a little more emotional than institutions. So there’s been a lot of selling of municipal bonds this year. And as a result, prices have fallen. Some people speculate that it’s from tax loss selling. When you think about it, municipal bond investors by definition are very tax sensitive. So seeing losses in the bond funds, they’re selling to take losses. Whatever the reason is, prices have gone down and muni yields have gone up.

00:15:03 – 00:20:03
So now get in a mid two to 3% yield federal tax free in muni’s is on the table. We haven’t seen an opportunity like that in a long time. So that’s an area that we’re looking to start to add in certain client portfolios. That makes a lot of sense. You touched on this a little bit in terms of valuations and also how international markets performed in July, but what are you seeing more broadly outside of the U.S.? Yeah, outside the U.S., emerging markets are interesting. There’s a lot going on there though. I mean, just yesterday that it was China, Taiwan, it is kind of a mess. But we do think that that is set up to be a good place to invest if you have the time horizon, which investors who are buying stocks in general should. I guess I would point to when you’re looking overseas emerging markets -we think that is attractive, because really the picture can’t get much worse. And valuations just support it as a good entry point. When we talk to our managers, our foreign managers, the emerging market managers are pretty bullish right now. And sometimes you can sniff out like, are they just selling product or is it genuine? And they’re finding opportunities, good valuations, good entry points and companies they’ve been following for a while. So it is an area we like and as part of rebalancing we’re adding there. What else is on your team’s desk right now? We’re looking at private equity. Private markets are interesting in some areas they are keeping pace with public markets as far as negativity and opportunities, but others they’re not. So valuations can still be a little high, so we’re sorting through that, but that’s the main thing. And we’ve talked about a lot of it with bonds. It’s been a lot of work going through the bond market as the yield curve has change so much this year, looking through different sectors. So that’s most of it. Thanks for that overview, Bob. And it sounds like your team has been busy, but summer also brings some opportunities to unwind a little bit, maybe crack into a couple of books. Have you ever read anything recently that you would recommend to our listeners? That I would recommend to our listeners? So it depends on what you’re interested in. A little nerdy. Assuming they’re you and interested in the same things you are, Bob. Ray Dalio, the changing world order. Well, Ray Dalio, you know, runs and founded Bridgewater Advisers, one of the largest hedge funds in the world. He wrote a book and it looks at the U.S. and different countries going back for centuries. And it does paint an interesting picture on the future of the U.S. Frankly, it is a little negative, so you have to read it with a bit of skepticism. But it does point to the potential that the U.S. may not lead the world forever. It looks at how countries take power and then eventually, you know, they don’t stay in the lead forever. And it just goes through the different things that you see as a country starts to lose its power and you’re seeing some of them in the U.S. So like political divisiveness, income inequality, funding foreign wars, so it’s not really an uplifting book but it goes through history and definitely makes you think about things a little bit more. Yeah, he’s an extremely thoughtful guy and he shifted to this phase of his career where he’s sharing a lot of what he is learning in his research and he’s got a few of these books, including the first one Principles, which I think I would broadly recommend, as would you. We’ve talked about that in the past. Any others? No, I just started Mary Childs, The Bond K, a story about Bill Gross and so far it’s interesting. And I think we might be talking about that in a future podcast. Yeah, that’s a great book. I read that a while ago and recommended it through my Wednesday reading list on thebostonadvisor.com and we are having a podcast episode with Mary because there’s a lot of fascinating aspects to the Bill Gross Pimco story that individual investors can learn a lot from and a new perspective on what happened during the Great Recession and how to choose managers and things of that nature. So yeah, that was a great one as well. Thank you, Bob for sharing your thoughts on the markets and the investment universe. I think it’s always instructive for our listeners to hear somebody who oversees a team managing over $2 billion on what we’re thinking and what they could be thinking about. And I look forward to future episodes at the beginning of every month. Thanks, Sammy.
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*This automated transcript may contain grammatical errors.