What a difficult year. Whether you're a slow as you go investor who likes fixed income or an equity investor who loves to take risks, it's been difficult. Benchmark indexes for just about every asset class have seen significant markdowns. To make it worse, the talk on the street is all about the coming recession, earnings compression, and general economic doom and gloom. Less discussed are the reasons for optimism. The year after midterms has historically been a fantastic year for stock markets. Combine that with some fundamental tailwinds as inflation data starts to come in softer and the Fed starts to reduce the pace of rate hikes, and we could start to see some real opportunities in this market. Historically the market has done exceptionally well in the years after midterms. In terms of numbers – the 12 month period after midterms has averaged just over 16% over the past 60 years - well over the long term average return for the S&P 500 which is just over 8%. Part of that outperformance is totally spurious, but the potential split in power in Washington DC could bode well for America's corporate outlook. While many in the media view the split in politics as gridlock and characterize it as a negative, many in the corporate world might actually view this as a goldilocks environment where they can thrive. This is especially true since the $1.66 trillion bill funding the US Govt for fiscal 2023 has already been signed. The rationale is simple: while political stagnation is typically frowned on by constituents who want their views touted, corporations love stable rules and policies. Give companies a stable playing field and they can plan further into the future, rationalize headcount, optimize their capital expenditures, and make strategic acquisitions. Stable playing fields give well run companies opportunities to execute on their plans and generate returns for their shareholders. TOPSHOT - Voters cast their ballots. (Photo by Frederic J. BROWN / AFP) (Photo credit should ... [+] read FREDERIC J. BROWN/AFP via Getty Images)AFP via Getty Images Stability will likely extend beyond the political landscape into the realm of economics. Sure, things are volatile right now, and it's still possible we see more down side, but the big macro pressures are starting to ease. The pace of interest rate hikes is set to decline and inflation is slowing down; we might even end up heading into a deflationary environment depending on how things play out. Yes, a recession is probably in the cards, but this is one of the most well telegraphed and anticipated recessions of all time. And, a garden variety recession is definitely easier to handle than an aggressive Fed and uncertain inflation. Plus, the downturn is being driven explicitly by the Fed; they're being really transparent about it. The language they're using is unambiguous and the action they're taking is calculated to crush the economy – it's the only way they feel they can ensure inflation doesn't run away. To paraphrase their statements in recent press conferences; price stability is far more important than a potential economic downturn and we can support the economy if there is a significant downturn. That kind of transparency has led to an environment where companies and consumers are actually being conservative in advance of the real economic pressures from the increasing cost of money.
There's a massive difference between a premeditated or orchestrated recession and one due to unforeseen systematic risks like what we saw in 2008. In today's environment companies are aggressively preparing for the downturn while consumers are similarly being cautious. You could actually make a strong argument that big corporate has been looking forward to an environment like this. Consider the following:
During the Covid 19 pandemic's early stages companies had to rapidly adapt to remote work and deal with complex shifts in hiring, managing, and distribution. The market opportunity was there, revenue growth was there, and so what mattered was producing more product. Plus, money was cheap; with interest rates near zero it made sense to invest heavily in growth. But hiring and managing remotely is really hard. Do you think every employee big corporate hired from a distance was a good hire? Probably not. Do we think every employee efficiently shifted from office to remote work? Probably not. But companies couldn't afford to get rid of those employees during the downturn – the optics of firing during a pandemic were terrible, and finding replacements was incredibly hard.
Today, companies everywhere are looking to rationalize their human capital and tighten up margins. It's not a bad thing, it's just a numbers game. If you hire 100 people, a few of them aren't going to fit in or perform as expected. You expand into 10 new markets, one or two of them isn't' going to sell like you thought. You roll out 5 new products and one of them turns out to be redundant. You need downturns to refocus and rationalize costs.
The big takeaway from this is that companies making cuts isn't bad. The looming recession is a great reason for them to drive efficiency and refocus on margins after years of focusing on revenue growth. It's healthy, and the companies who tighten up to execute more efficiently will be the ones who come out stronger on the other side of the recession.
Anticipating The Recovery:
While there's been a lot of talk about the coming recession, there's been far less talk about what happens next.
The recovery is what investors need to be focused on.
It feels far away, but it's not. Remember, the market is forward looking. Right now the market is pricing companies for what they expect the recession to look like. The recession could be better than expected, could be worse than expected, but right now the markets are pricing in a lot of bad expectations. Fast forward things a bit – when the real economy is in a recession the market is going to be looking forward to the return to growth. As an investor, you need to spend the next few months making sure you're in the right position for the recovery.
Don't worry about the recession, they have happened before, and they'll happen again – position yourself for the recovery because when the Fed starts to cut rates and the economy starts to stabilize and then pick up steam, it will happen fast and markets will run.
And rate cuts are going to come. I know it feels silly to talk about – the Fed is still hiking and is adamant they're going to hold rates higher for longer to make sure inflation comes down. But when that's done, they're going to cut rates. They've said so in plain English, and their dot plot projections show the same thing. Fixed income futures are already pricing some cuts in. Intuitively it makes sense as well – inflation is coming down and unemployment is starting to inch up; the economy is going to need support.
Plus, there's going to be intense budgetary pressure to bring rates down as well. Fed rates have a direct impact on US debt servicing costs and most US debt is in shorter duration instruments. We don't have a huge amount of our debt in 10 – 30 year bonds where we don't have to worry about the interest rate resetting. Quite the opposite – most of our debt is nearer term maturities and every month that we keep rates high is another month that we add to our debt service costs.NEW YORK, NY, UNITED STATES - 2018/07/13: The National Debt Clock is a very large digital display of ... [+] the current gross national debt of the United States. It is mounted on a western facing wall in a wide covered alley in the middle of the block and runs between West 42nd Street and West 43rd Street. The alley is located between Sixth Avenue and Broadway in New York City. The displayed debt shown, over 21 trillion dollars, is as of July 13, 2018 when this image was created. (Photo by Michael Brochstein/SOPA Images/LightRocket via Getty Images)LightRocket via Getty Images
Building The Portfolio:
Opportunities are everywhere in a market that's been beaten up like this but there are a few spots we'd highlight for people depending on what kind of risk they want to take on.
For those who are more conservative, fixed income markets are a real investment opportunity for the first time in years. The yields in fixed income are attractive, while rate risk looks to be abating with the Fed slowing down their rate hikes. Credit risk is edging higher as we head towards a recession, but broadly speaking, corporate balance sheets are healthy and credit defaults aren't a huge concern for most of the market. Plus, the healthy yields are compensating you for the default risk you're taking on in the world of corporates.
Strong corporate balance sheets and resilient cash flows are also the primary drivers behind why we think the big companies like Microsoft MSFT or Google or Amazon AMZN are solid portfolio building blocks. They're not the most exciting names in the market, but it's hard to ignore wide moat leaders in their spaces trading at attractive multiples. If you're just getting started or you're risk averse, you don't need to get complicated – just get the big blue chips at a discount.
For those who are willing to take on more risk there are even more options on the table. Sure, the ride is going to be more volatile – it's hard to time the bottom and we have several months of uncertainty ahead of us – but if you have longer time lines, then now is when you start looking at building that risk-on portfolio. Small caps, beaten up growth names that will rise with rate cuts, companies with multi-year growth trajectories like MongoDB or Snowflake or ON Semiconductor.
Finally, if you have a long time horizon and can tolerate some risk, then you have to look at private equity or venture capital. These are key components of the modern diversified portfolio that most retail investors are seriously underexposed to. Plus, private equity and venture capital vintages seeded during downturns have historically outperformed other vintage years, in addition to beating the broader public investment marketplace.