Your Recession Playbook | Portfolio Strategy
Summary
The chances of a recession continue to increase and we believe now the base case scenario following last week's CPI report.
With inflation not budging despite tighter monetary conditions (albeit slightly), the Fed finds itself behind the 8-ball and needs to react more aggressively.
We think investors should de-risk out of high yield and loans at least, and focus on high quality like investment grade, munis, and government bonds.
The economic regime will ultimately will be the driver of where we should be invested today. We will detail that some today and more in subsequent reports.
At this point, we think a recession is inevitable. The markets are certainly pricing one in now with the S&P 500 formally entering a bear market. The CPI report on Friday essentially confirmed the need for the Fed to continue to push the brake and slow the economy, likely into recession.
According to the Financial Times, over 70% of economists now think the US will slip into recession by the middle of next year. That is up from a mere 10% at the start of the year. And the percentage has climbed rapidly in the last few weeks.
When does the pain end?
The pain won't end until inflation expectations match or exceed reality. Right now, the market continues to price inflation to fall not that far from the present day. In other words, the market continues to assess peak inflation very close to 'now'.
The chart below shows that. The dotted colored lines are expectations from that point in time. You can clearly see that they are always falling- even today with the orange line peaking right now and then heading lower.
The markets won't head higher until that is a reality. The reason is simple: if the market continues to underprice the risk of a more hawkish Fed, it cannot bottom. We saw this in the last two trading days. Inflation hasn't peaked and now the market is projecting more hawkishness from the Fed, and it took a tumble.
The problem for us is that inflation is still rising- mostly thanks to rising oil prices and contracting corporate profit margins due to higher labor and commodity costs. So we won't even know that we've peaked until several months from now- at the earliest.
In other words, this volatility and further downside should be expected for the rest of the summer, if not longer.
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