For much of 2023, we’ve been among the chattering crowd of investment professionals who’ve been repeating the same questions: Will the U.S. Federal Reserve’s (Fed’s) rapid rate-hiking cycle push the economy into a deep recession—a so-called hard landing? Or might the pain from extreme monetary tightening be more subdued, resulting in a soft landing, with only a modest drag on the labor market and no actual recession? Perhaps a third scenario could play out: no landing at all—a sort of economic purgatory—with the current regime of slowing growth and modestly high inflation extending into 2024, without a recession or a clear exit leading to recovery?
From our perspective, we’re still in a late-cycle environment, and a recession will eventually materialize. Given the aggressively fast Fed tightening that we’ve seen, and the steepening in bond yields entering this year’s fourth quarter relative to the more modest rise in the prior two quarters, we expect that the resulting increase in companies’ costs of capital and consumers’ borrowing costs will eventually cycle throughout the broader economy. The lagged effect effect of the Fed's policies means that something will break at some point—potential triggers could be an unexpected geopolitical or financial crisis or a spike in energy prices, for example—and the likely outcome will be a recession. For a soft landing to occur, the Fed would have to fully transition to a rate-cutting mode. That’s an unlikely near-term scenario, in our view, given the recent economic uptick that we’ve seen and the challenges that it presents for the Fed’s current goal of keeping inflation on a downward trajectory toward the Fed’s 2% long-run target rate.
As for the investment implications, we see plenty of reasons to remain cautious in terms of portfolio positioning but without abandoning equities or other higher-risk asset classes. In our view, the latest economic indicators are flashing yellow rather than red or green. Instead of slamming on the brakes, we think it's time for investors to ease off the gas, slow down, and stay alert for trouble while also being mindful that the light will eventually turn green again.
To better understand how we got here, we’ll highlight three unique circumstances that continue to fuel today’s high level of uncertainty and raise the possibility of a “no landing” scenario.
1 There’s no precedent for today’s postpandemic environment—COVID-19 was unlike anything we’ve experienced since the influenza pandemic of 1918/1919, and it’s hard to draw economic parallels with the more recent health crisis, which saw supply chain disruptions and large government stimulus packages followed by spiking inflation. Today’s global economy bears little resemblance to the one we had a century ago, and the economists, policymakers, and political leaders who engineered the stimulus and inflation-fighting measures of the past few years had few historical lessons to draw from, creating a highly uncertain outlook.
2 GDP has already been negative for two consecutive quarters, but it hasn’t been declared a recession—U.S. GDP has been all over the place since the pandemic: It followed a bust/boom cycle early in 2020 before reaching a 7.0% annual rate in 2021’s fourth quarter, followed by two consecutive quarters of negative growth in early 2022. By virtue of that back-to-back contraction, early 2022 met a narrow definition of a recession. Yet the National Bureau of Economic Research—the most widely followed arbiter of recessions—hasn’t yet declared that stretch as a recessionary period, given the resilience that we’ve continued to see in the labor market and in consumer spending.
3 This rate-hiking cycle has been unusually rapid, so any avoidance of a recession would be exceptional—The Fed raised its federal funds rate from near zero in March 2022 to the current target range of 5.25% to 5.50%, a level reached when the Fed approved its most recent increase on July 26, 2023. We’re not aware of any precedent in which the Fed has raised rates that much and that quickly without triggering a recession.
The mixed signals that this economy is sending
The current extended late-cycle economy has produced an environment that’s become choppy and challenging for investors, with each new economic report providing another reference point as to whether the Fed may lean more toward policy tightening or easing. Lately, we’ve seen expectations of further tightening and a higher-for-longer rate outlook, which has weighed on bond prices, sending yields higher. That dynamic has been a negative for stocks, as investors compare the currently attractive yields for newly issued bonds against the income potential from dividend-paying stocks, which are typically more volatile than bonds. While there’s been a general uptick in economic indicators, they haven’t been positive across the board. U.S. purchasing manager indexes—drawn from surveys of corporate purchasing managers responding to trends in their industries—have shown a modest contractionary trend on the manufacturing side but a continuing expansionary trend on the services side. Another U.S. gauge that we watch closely, The Conference Board Leading Economic Index, has remained deeply negative, falling each month for nearly a year and a half, suggesting strong potential for a recession.
As for the labor market, September’s jobs report provided an upside surprise, as the monthly gain of 336,000 jobs far exceeded expectations. Furthermore, prior estimates of jobs growth totals from July and August were revised upward by a combined 119,000, and new claims for unemployment benefits recently dropped to an eight-month low. Looking at GDP, the latest second-quarter reading came in at an annual 2.1% rate, down only slightly from the first quarter’s 2.2% figure and still solidly positive.
Taken together, these numbers suggest to us that the Fed will become more inclined to believe that the economy is strong enough to withstand the impact of one or more additional rate hikes in the near term and that its likely eventual transition to a rate-cutting stance can be put off further. However, over the longer term, the extension of the Fed’s tightening cycle could mean that a recession is more likely, just pushed further into the future than if we hadn’t seen the recent uptick in labor and economic data.
The investment implications of three different economic scenarios
As for how the economy’s direction influences our own asset class views, it’s worthwhile to explore the characteristics typical in the three major scenarios that could play out from here.
Three economic cycle scenarios
|Hard landing||Soft landing||No landing|
|A recession, typically followed by a broad recovery; typified by rising unemployment and shrinking consumer spending and business activity; policymakers typically respond with rate cuts and stimulus||A recovery from a period of slow growth without a recession; economic indicators show a slowdown in growth but not an extended contraction, and the direction of rates may be variable depending on the level of inflation||Growth remains slow to stagnant for an extended period, with no clear transition into a recession or a recovery; the direction of rates may be variable|
Source: John Hancock Investment Management research.
Here's how we’re framing our asset class views
Whichever environment we see in the near term, our cautious approach to the market outlook reflects our emphasis on more defensive sectors within equities and an overweight in the quality factor. Among the characteristics of quality stocks are strong balance sheets, more durable profitability, higher return on equity, and less need for capital in a period of higher borrowing costs. We generally prefer large and mid caps over stocks with small market capitalizations, as we’re seeing a relatively large number of small caps that are currently unprofitable; as a result, the quality factor has become increasingly important in small-cap security selection. Geographically, we’re modestly leaning into U.S. equities over international stocks, as the U.S. economy appears to be holding up well relative to the rest of the world and is in a later stage of monetary tightening than most peers are.
In fixed income, we’re seeing value in high-quality bonds, where yields have reached the highest levels in 16 years by some measures. Among the segments that we view as attractive are U.S. investment-grade corporate bonds, mortgage-backed securities, and municipal bonds. In contrast, high-yield debt and floating-rate debt appear to be expensive, given current macroeconomic risks.
Our fixed-income views have recently taken on somewhat of a contrarian tilt, as some riskier segments of the bond market have outperformed higher-quality areas this year, owing in part to the fact that U.S. economic data has generally come in better than expected. However, we believe that moving up in credit quality could be a sound approach, as the full impact of rate increases hasn’t yet fully cycled through the economy, and we could see higher borrowing costs weigh on growth over the next several quarters. In such an environment, high-quality bonds are likely to hold up better than riskier segments of fixed income, in our view.
If our economic outlook turns out to be wrong and it becomes clear that we’re experiencing a soft landing, we’d embrace a measured, selective approach to dialing up risk across asset classes. If it appears that any excess levels of debt or lofty market valuations have been flushed out of the economy and the markets, we’d take a fresh look at more offense-oriented cyclical equity sectors and value stocks. In fixed income, certain segments of lower-rated debt may begin to hold more appeal than their investment-grade counterparts. If neither a soft nor hard landing materializes, and we see more of the same, our asset class views aren’t likely to materially depart from our current thinking. At John Hancock Investment Management, we offer resources on late-cycle investing and addressing changes in market cycles to help inform your portfolio decisions. In addition, our latest investment outlook is presented in greater detail in our latest Market Intelligence quarterly update.
A disciplined approach to a highly variable environment
Given the current uncertainty about where the economy is headed and the many variables in play, we’re trying to stay patient across asset classes and identify pockets of opportunity that may become overlooked by the broad market, as reflected by low valuations that may provide a margin of safety if economic trends turn negative. By adapting portfolios to each stage of the economic cycle, we ‘d look to increase higher-quality bond exposure and then look to increase equity exposure when it becomes apparent that a new cycle has begun.
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The views presented are those of Emily R. Roland, CIMA, and Matthew D. Miskin, CFA, of John Hancock Investment Management Distributors LLC, and are subject to change as market and other conditions warrant. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Any economic or market performance is historical and is not indicative of future results, and no forecast is guaranteed. Past performance does not guarantee future results.
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