July 2022 Market Outlook
Market Outlook
Some of you may remember the classic daytime game show “Let’s Make A Deal” which aired on NBC from 1963 to 1977. Contestants selected one of three doors in hopes of winning a grand prize. The game host (many will remember Monty Hall) reveals one door behind which there is no grand prize after the contestants have made their initial selection. He then gives the contestants a chance to switch to the remaining unchosen door. The statistical best choice is to always switch doors![1]
We reference the Three Door Game metaphor in part to share a brain teaser about statistics but primarily because some economic forecasters are using the “three doors” decision tree diagram to assess recession risks in the second half of 2022 or late 2023.[2]
J.P. Morgan Markets
Door 1: 40% probability of a second half 2022 supply shock induced recession brought about by the unceasing headwinds of inflation and tightening financial conditions.
Door 2: 18% probability of late 2023 Central Bank induced recession.
Door 3: 42% probability of a sustained soft economic landing through 2023.
Market views appear divided between those focused on the stubborn high levels of inflation and continued supply chain disruptions which are coinciding with rising interest rates and fuel costs. One can argue that the equity markets have already priced in a pending recession with 1H22 equity indices being down over 20%.
However, any prediction of a near term recession must ignore the strong fundamental economic metrics reflected in the tight labor markets, manufacturing production growth, and solid consumer and commercial balance sheets. We will get further insight into the underlying economic strength and 2H22 forecasts with 2Q22 corporate earnings. Yet, economic strength does exist amidst the gloomy reality of negative business headlines, higher grocery bills, record-breaking gas prices, and a protracted war in eastern Europe.
Over the past several quarters our Cassia newsletter has highlighted the unprecedented growth in the money supply (measured by M2) which was injected into the economy via quantitative easing in the form of bank credit reserves to counter balance the stunning decision to shut down the economy during the pandemic. While M2 has grown approximately +5.4% annually between 1986 – 2020, its annual growth rate surged to over +18% since February 2020. Although supply chain disruptions have contributed to rising costs, the excess liquidity in the system through ample bank reserves and cheap credit has been the primary contributor to raging inflation and elevated asset prices in our opinion.
Therefore, we believe monitoring ongoing M2 growth will provide an important lagging indicator of future recession risk as well as handicapping the Federal Reserve’s ability to engineer a soft economic landing in the context of solving runaway inflation.
It was encouraging to see that the most recent M2 report for May (issued at the end of June) showed slowing M2 growth closer to the historical +6% annualized pace. However, a more determined monetary policy for battling inflation might require significantly lower levels of M2 growth, possibly between 0% – 4%. The sharp reversal in liquidity or bank credit reserves is what makes the likelihood of a soft economic landing very difficult to achieve. It is also why many economists do not see a recession hitting before 2023.
Markets are efficient and will price future expected economic outcomes into stock and bond prices today. And the speed and fluidity with which markets reach a new consensus about corporate earnings and overall economic growth are what support maintaining appropriate levels of investment throughout the cyclical nature of GDP growth.
At Cassia, we chose Door 3, and it seems like the real economy is not behind Door 1. Therefore, we are switching to Door 2 and expect some form of recession later next year. The implications to our model portfolios are continued lower equity exposures, shorter duration fixed income allocations, and modest allocations to real assets and liquid alternative strategies. In our opinion, a risk-based diversified allocation, with an active/passive investment approach, will provide the discipline and adaptability to navigate market conditions throughout the remainder of the investment cycle.
[1] The statistical reason for switching doors: contestant choses one door out of three which has a 33% chance of holding the grand prize. The other two doors represent a 66% chance. When Monty Hall reveals that one of the two other doors does not have the grand prize, the remaining door in the group of two retains the higher 66% probability. Therefore, one should always switch as your probability goes from 33% to 66%.
[2] See J.P. Morgan Daily Economic Briefing: “When the Bough Breaks”, July 8, 2022.