Mid-Year 2022 Review: Nine Sources of Increased Risk

With that said, here is a quick review of nine areas of heightened risks:

1. The COVID crisis led to massive fiscal stimulus, producing the huge budget deficit that has pushed our debt-to-GDP ratio well above 100%, a level at which the empirical evidence demonstrates has had a negative impact on economic growth. Thus, financial plans should at least consider that possibility, which leads to lower equity returns. In addition, the massive increase in the Federal Reserve’s balance sheet, from about $2 trillion in 2010 to about $9 trillion in June 2022, a result of the Fed’s policy of trying to suppress interest rates through bond purchases, has added to the inflationary pressures caused by the massive fiscal stimulus, putting pressure on bond yields. While safe bonds, like U.S. Treasury securities, have performed well when stocks performed poorly because of negative demand/deflationary shocks, both stocks and bonds have tended to perform poorly during high inflation regimes, like the one we are experiencing now. During such periods, safe bonds have lost their diversification benefits.
2. The COVID crisis disrupted supply chains, leading to inflationary pressures. This has important implications, as the globalization of supply chains not only had a deflationary impact on prices but also on innovations like just-in-time inventory management, which led to improved productivity, profits and economic growth. The COVID crisis has caused countries and companies alike to reconsider the implications of their reliance on offshoring supplies, likely leading to more onshoring (domestic sourcing). The result could be higher prices, lower economic growth, lower productivity and lower corporate profits.
3. Russia’s invasion of Ukraine combined with the economic sanctions placed on Russia created further supply and inflation problems. Russia a major oil and gas producer, and it and Ukraine are two of the world’s largest exporters of wheat, accounting for almost 30% of global exports. And the two countries play a dominant role in world sunflower oil supplies, shipping about 80% of exports. In addition, global supply chains rely on components and little-known commodities from Russia such as neon gas and palladium, important ingredients to make semiconductors, which has negative implications for many products. Russia is the main supplier of gas to several European countries, creating greater risks for Germany and Italy in particular. If Russia cuts off gas shipments to them, that could have a significantly negative impact on their economies, likely producing a recession.
4. While the massive fiscal and monetary stimulus helped fuel the strong economic recovery in the U.S., it also led to the tightest labor market we have ever had, with almost two jobs posted for every unemployed person and an unemployment rate of only 3.6%. Exacerbating the problem of a tight labor market is that the COVID crisis led to the early retirement of many workers (e.g., the shortage of pilots), making the labor market even tighter, leading to increased pressures on wages and further fueling inflation. The move to onshore jobs will further tighten the labor market. Tight labor markets, while good for wages, has the reverse effect on corporate profits. Thus, we could see a margin squeeze as the negotiating power shifts from employer to employee.
5. Government policies to discourage carbon-related energy production and distilling capacity, combined with the need to transition to greener forms of energy, have negatively impacted supplies, increasing inflationary pressures.
6. The much stronger fiscal response to the COVID crisis by the U.S. resulted in our economy recovering faster than that of the rest of the world and our interest rates rising faster as well. That has led to a dramatically stronger dollar. From September 2021 through end of June 2022, the dollar rose from about 92 to 105, hitting a two-decade high of almost 106 in mid-June. The stronger dollar puts pressure on exports and increases our imports, increasing our trade deficit. This has negative implications for economic growth as well as for corporate profits due to the falling dollar negatively impacting the earnings of U.S. multinationals. That could lead to reduced earnings forecasts, resulting in lower P/E multiples.
7. The effects of reduced fiscal stimulus (a result of shrinking fiscal deficit), significantly tighter monetary policy (as the Fed both raises interest rates and shrinks its balance sheet) and the stronger dollar are likely to result in slower economic growth, increasing the chances of a recession.
8. All these issues have resulted in a sharp drop in consumer confidence. The Conference Board’s expectations index, based on consumers' short-term outlook for income, business and labor market conditions, tumbled to 66.4, the lowest level since March 2013, from 73.7 in May. As the consumer confidence index is a leading indicator, it signals that the risk of a recession within the next year has increased. However, the empirical evidence demonstrates that buying stocks when investor sentiment is negative has led to much higher returns than when investor sentiment is positive. The logic is simple: Negative sentiment leads to large risk premiums and thus low prices and high expected returns. Returns are likely to be poor only if the news turns out to be worse than already expected, which is a random occurrence.
9. With the debt-to-GNP ratio now in excess of 100%, the Fed has a difficult task in its efforts to fight inflations, as each 1% increase in interest rates leads to an increase of about $250 billion in interest costs and the budget deficit.

Outlook for the U.S. economy

Everything previously discussed is well known by the market, which explains why stocks and bonds have both performed poorly this year. However, it doesn’t tell us much about the future other than that there are heightened risks, and the dispersion of possible outcomes has widened. It doesn’t matter to markets if the news is good or bad, only whether it is better or worse than what was expected.

The second quarter 2022 consensus forecast of professional economists is that GDP growth will slow to 2.5% in 2022 and 2.3% in 2023, the unemployment rate will remain unchanged in 2023 at 3.6%, and inflation will fall to just 2.9% in 2023, i.e., slower growth but no recession. Monetary policy is still very loose, with negative real rates of interest; there is still some fiscal stimulus (just not as much as in 2020 and 2021); and both corporate and consumer balance sheets remain strong. However, that doesn’t mean there is no risk of recession, especially if inflation remains persistently high. The housing component of the CPI represents about one-third of the CPI and about 40% of the closely watched core CPI, and it has a significant lag because of the way it is calculated. Rents have been rising sharply and will likely continue to do so, as housing supply is limited and labor markets are strong. That will create upward pressure on rents and the CPI. There’s also the risk that the Fed is behind in tightening policy sufficient to dampen inflation. If that proves to be the case, it will have to raise rates higher than the market expects. The following chart shows the mean probabilities of real GDP growth in 2023:

The future is not knowable, and investors should treat the mean forecast of 2.3% growth in a probabilistic and not deterministic way.

In addition to raising rates, the Fed will be reducing its balance sheet by almost $100 billion a month starting in September. Given the magnitude of the reduction in the Fed’s holdings, we have no precedents to draw upon to help with a forecast of the impact of such a tightening of liquidity in credit markets. And just as rates were pushed down when the Fed was buying trillions in debt, its selling or allowing the runoff of hundreds of billions of securities could push interest rates higher than is currently priced into the market. Higher rates than expected would be a negative for both stocks (particularly longer-duration growth stocks) and bonds. Given those unknowns, the current odds of a recession in the next 12 months are perhaps 30% to 50%. Investment plans should be designed to handle the risk.

As to interest rate risks, the historical evidence is a guide to possible outcomes. Let’s assume you are an optimist and believe the Fed will achieve its goal of 2% inflation in the relatively near term. If the roughly 0.5% historical real rate on T-bills and the historical term premium of 2% are added to that, it results in a 10-year Treasury yield of 4.5%, a level that would likely not be good for either stocks or bonds, as it is much higher than the market expects. And if you’re a pessimist on the outlook for inflation, the yield could end up much higher.

Summarizing, there are two big risks for investors: The war in Ukraine drags on, continuing to create supply pressures, keeping commodity prices elevated and creating a drag on the global economy; and inflation runs hotter than the Fed and markets expect, causing it to raise rates more than already anticipated. Also, there is the risk of an unexpected “black swan” event (such as the COVID crisis). Investors should always build that risk into their plans.

What should investors do?

What should investors do with this information? If you are concerned about these risks, there are two ways to address your concerns. The first is to reduce exposure to both stocks and bonds and increase your exposure to very short-term, safe bonds. That means accepting negative real returns. And timing the market has been shown to be a loser’s game because you have to be right twice – once when getting out and then when to get back in. Thus, the more prudent way to address the risks you are concerned about is to diversify your exposure to risk assets to include other sources of risk that have low to no correlation with the economic cycle risk of stocks or the inflation risk of traditional bonds. The following are alternative funds that may provide diversification as mentioned above. Alternative funds carry their own risks; therefore, speak to your financial professional based on your own circumstances prior to making any adjustments to your portfolio.

• Reinsurance (such as SRRIX and XILSX);
• Private middle market lending (CCLFX and CELFX, which add other unique risks such as life settlements, litigation finance and drug royalties);
• Consumer credit (LENDX);
• Long-short factor funds (QSPRX and QRPRX);
• Commodities (DCMSX); and
• Trend following (QMHRX).

As Kevin Grogan and I demonstrated in our book, Reducing the Risk of Black Swans, adding unique risks has historically reduced the downside tail risk associated with conventional stock and bond portfolios. While stocks and bonds have both produced large losses in the first half of 2022, each of the alternatives above has produced positive returns just when needed most.

Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-319

Read more articles by Larry Swedroe