The US market has certainly been whiplashed to start the year on the fears the Trump administration and renewal of trade wars will throw the US into a recession. I would like to discuss my view on the debate and would be happy to have discussions, hear counter arguments, and see other points of view.
The trades we have seen over the last month are just that, fear. Fear tariffs will reignite inflation and embark us on a long, drawn out trade war that will hurt demand. Fear unemployment will tick up. Fear we will not be able to cut rates like many businesses desperately need. Fear of a recession. But have we seen the signs to point us into believing a recession is upon us?
It is clear that this is a broad risk-off trade with the most speculative and riskiest assets that have appreciated the most in recent years have taken the biggest hit - even if they would see little to no impact from tariffs. Speculative and momentum driven assets like Bitcoin and Tech lead the sell off as investors flee to safer assets such as underappreciated international markets, fixed income, defensive industries like health care and consumer staples. This is evident with the depreciation of the dollar as investors sell US holdings in exchange for internationals, the steep drops in 10 year treasury yields as demand for T-bills rise, and the outperformance of defensive industries over the past few weeks. While I have personally been begging for a decline in a vast amount of US stocks for the past 1-2 years due to overvaluation, I think we all would have preferred that came from a different catalyst than trade wars. Nonetheless, this sell off and decline in US equities will present very lucrative buying opportunities.
Lets talk about some signs that things may not be as bad as they appear:
\- Inflation is the biggest indicator the markets has it's eye on. Current levels of CPI readings are sitting around 3.0%, slightly above the 20-year average of 2.6%. Following readings of this over the next few months will obviously be very important to get a gauge of the true impact tariffs are having on the economy.
\- Unemployment remains relatively low historically speaking at 4.1% compared to the long-term average of 5.8%.
\- Credit spreads remain near the lowest levels that have been seen in decades. The debt market is certainly not reacting as strongly to the fear of recessions. Corporate balance sheets remain very strong and the probabilities of default have not risen for major issuers. This is often a very strong indicator that economic health can remain strong. Though they are starting to widen slightly, it is not to the level you would see when a recession is on the horizon.
\- With the level of risk and fear in the market I would have expected the VIX to be higher than where it is currently sitting at 27.7. While this is higher than averages and shows some level of risk being priced in, it certainly is in line with 2022 during rate hikes and well below levels seen during the shock of COVID.
Why is the market so fearful of inflation when we just weather through one of the highest levels of inflation seen in decades?
Fairly simple. Consumers had pent up savings that peaked in 2022 reaching almost $3T in excess savings from COVID stimulus that helped them to weather the increase in prices. At this point the majority of that has been spent for the bottom 90% of earners. The top 10% has actually maintained this savings level and is still near highs of excess savings. The top 10% now accounts for 50% of all economic growth and spending - a concentration that can make you feel uneasy. The other main component is the weaking in the job market we have seen since 2021. The number of new jobs added has steadily declined for years and with the prospect of increasing lay offs it is going to be more difficult to find a new job than it was a couple of years ago. All in all another round of severe inflation would be much more impactful this time around. An important question has to be asked though, would inflation from tariffs be nearly as bad as the inflation we saw from spikes in energy prices that affect every industry and global supply chain disruptions that lasted years? I think not, but that is up for debate.
So how do we invest in a market like this? If you're a long-term investor I truly believe what is going on is noise to you and you should be celebrating the prospect of picking up high quality companies or dirt cheap as this sell off continues. Valuations on companies that continue to generate very strong cash flows and have wide, long lasting economic moats have cratered. The longer this persists, the more cash I will be getting ready to deploy. To tactically adjust your portfolio moving into Staples, Healthcare, Real Estate, and other defensive industries will continue to be a safe haven. XLP, XLRE, XLV will all provide the broad exposure to defensive US companies and remain in positive territory of between 4.5-8% on the year. Remaining diversified in international markets that have been undervalued for decades seems to be the direction many investors are going. Fixed income remains of course very safe and as treasury yields continue to decline, you can see some solid capital gains along with the steady income they provide. This may be smarter than holding in HYSA or MM cash accounts that will see their rates fall if we go into a recession. There are always opportunities.
When I see this level of fear in the market I tend to get excited as I know it means high quality companies will be oversold. They may not be done yet, likely there will be further downside. I think a combination of becoming a little more defensive, but also preparing yourself for buying opportunities and sticking to a long-term, diversified strategy is the best approach. When this market bottoms, and it will, the surge in liquidity into the US market and the gains we will see will not be something you want to miss out on. Stick with your strategy and long-term view and everything will be just fine. Happy investing.