The U.S. economy surprisingly contracted by 1.4%, on a seasonally adjusted and annualized basis, in the first quarter of 2022. The consensus expectation for Q1 GDP, according to Bloomberg, was for a 1.0% gain, much slower than Q4 2021 GDP of 6.9%. While the number was negative, there were some positive components to the final number—such as strong imports, services, and purchases of durable goods (goods that are able to be kept for a period of time), which indicate a healthy consumer.
A slowdown in U.S. economic growth has been long expected, but the surprise contraction has led to increased chatter of a recession, broadly defined as two consecutive quarters of negative GDP growth, and the potential of an equity bear market along with it.
Our base case: an economic slowdown
While we were surprised at the negative announcement, a 2022 recession isn't our base case. Rather, we expect to see an economic slowdown, which could lead to a pivot in the U.S. Federal Reserve’s (Fed’s) hawkish narrative, and would be positive for both equities and fixed income. Despite the surprise, now’s not the time for investors to have a knee-jerk reaction in regard to their investment portfolio.
We have four simple rules that we like to use as a framework during these periods of heightened volatility. They’re loosely based on advice that hikers are given should they come face to face with a bear in the wild.
1 Vanquish fear and panic
When it comes to the stock market, there’ll always be a reason to sell. Negative headlines stoke fear in the minds of investors and that’s a natural reaction from a behavioral perspective. Loss aversion is a cognitive bias, which explains why individuals typically feel the pain of a loss twice as intensely as the equivalent pleasure of gains. As a result, individuals tend to try to avoid losses in any way possible.
Market corrections (a drop of 10.0% or more), like bear attacks in the wild, can happen at any time, are common, and very difficult to predict. Since 1980, the S&P 500 Index has fallen an average of 14.3% in any given calendar year, but is positive 78.0% of the time with an average return of 10.3%. In our view, the key is to position an investment portfolio defensively prior to recessions that correspond to large equity drawdowns.
Another cognitive bias when it comes to humans and investing is availability bias, where we tend to listen most to information that’s most readily available; for instance, we tend to read headlines and not the entire news article. It’s important that investors take in all available information and make a sound, informed decision rather than one based on the most sensational headline.
2 Know your environment
Our work suggests that the U.S. economy has begun to slow down and will continue to do so throughout the year. But let’s be clear: Despite the slowdown, the probability of a traditional U.S. recession taking place over the next 12 months remains low. When we say traditional, we’re referring to the typical recession that lasts 10 months (on average) and one that's often associated with elevated unemployment. That said, a technical recession, where GDP data contracts for two consecutive quarters, is possible, but we believe a sustained bear market is unlikely.
Historically, warning signs are often perceivable prior to a traditional economic recession—these include yield curve inversion and sustained weakness in the housing and labor markets. At this juncture, other than inflation (which was already signaling a higher risk of recession), two other indicators that typically point to an upcoming recession—the yield curve, as measured by the difference in yield between the 10-year and 2-year U.S. government bond and tightening financial conditions—have started to signal an economic slowdown. It’s important to note, however, that other signs of a recession aren’t present today, supporting our belief that the U.S. economy is slowing and unlikely to slip into recession.
Although U.S. economic data indicates growth is slowing, there’s evidence that corporate earnings remain quite resilient. We‘re almost halfway through the earnings season for Q1 2022 and 76% of S&P 500 companies that have handed in their results have exceeded expectations. These firms, however, haven’t been rewarded for earnings outperformance (in the form of higher share prices) as a result of the current negative sentiment. In earnings calls, many of these CEOs are talking about their plans to keep hiring amid existing tight labor conditions. Unemployment in the United States is very low at 3.6%—a level that’s arguably synonymous with full employment. It’s very rare to see recessions when unemployment is this low.
3 Take advantage of opportunities
For the long-term investor, it’s important to remain focused on the fundamentals. Warren Buffet attributes some of his success to being a contrarian investor. He famously said, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” Investors know this investment truism to be accurate, but it’s often hard to practice.
The Cboe Volatility Index (VIX) is a great measure of the amount of fear in the markets. When the VIX is high, there’s more fear among investors and vice versa. Since 1990, the VIX has averaged approximately 19 and a reading above 30 is an important level that signifies extreme aversion to equities.1
The VIX is now once again above 30. Historically, when the VIX has breached this level, the S&P 500 Price Index return has been positive more than 80% of the time one year later.1
History suggests that investors can improve their returns by becoming greedy and embracing risk at a time when others are fearful and selling. That said, in this environment, it’s also important to take advantage of the right opportunities: This isn’t a time to add to the higher-risk areas of the market but, rather, to be selective.
When it comes to predicting the number of Fed interest-rate hikes, the market is notoriously bad at it. During most rate-hike cycles, the market tends to be overly aggressive in its expectations for the number of hikes at the beginning of the cycle. At present, market expectations are for the Fed to raise the overnight interest rate a total of ten times over the next seven meetings, leaving the federal funds rate near 3% after the February 1, 2023, meeting.1 Should we see weaker economic data, it could give the U.S. central bank enough reason to pivot from its ultra-hawkish tone—any shift to a less hawkish stance would likely be positive for both equities and fixed income.
4 Don’t be afraid of what goes bump in the night: If something's meant to harm you, it’ll stalk you silently
There’s another relatively common behavioral bias called confirmation bias, where individuals seek out information to prove their beliefs. In the case of investors who are worried about the economy or markets, this means looking for articles or comments on the internet, social media, TV, or elsewhere that confirm their fears without attempting to look for information that’ll help calm their fears. While it’s important not to dismiss these fears, it’s also critical to gather all available information before coming to an informed decision. It’s likely that what they believe will cause the next recession and/or bear market won’t be the main catalyst; in all likelihood, it’ll be something completely different.
Our final thoughts—don’t run
Recent economic data is pointing to a slowdown in the U.S. economy and abroad; however, it’s important not to panic. Another golden rule regarding how to behave in a surprise encounter with a bear in the wilderness is not to run away, and that applies to investing. Take a step back, survey the environment, remember or revisit the plan, and stay on course.
1 Bloomberg, as of May 6, 2022.
Views are those of the authors and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.