The future of the economy

Coming up, we size up the future of the economy and the markets.

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From Thrivent Asset Management, welcome to episode 32 of Advisor’s Market360™. A podcast for you, the driven financial advisor.

With stocks in a bear market, inflation on the rise, and concerns growing over the possibility of a recession, we know how you’re feeling. It’s a difficult time for investors and financial advisors as a host of competing variables and bleak headlines vie for our attention. Where do we even begin? Let’s take a breath… and cut through the noise with the help of our very own experts. We check in with David Royal, Thrivent Chief Investment Officer, and Steve Lowe, Chief Investment Strategist, who spoke at a recent event for advisors and offered their assessment of six challenges facing the markets and economy. We’ve taken their dialogue and turned it into a short and sweet paraphrased package for you, our listeners.

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The six challenges that Royal and Lowe identified are as follows: inflation, the threat of recession, the bear market, volatility, interest rates, and real estate. Listen on as we cover them one by one.

Starting off with the first challenge facing the markets and the economy: inflation. Rising inflation caught the Federal Reserve, or Fed, off guard, and it was slow to respond as signs of inflation began to surface.

A year ago, the Fed did not anticipate any rate hikes until 2024. And even after inflation began to take hold, the Fed was slow to gauge how rapidly the cost of goods and services would rise. In other words, the Fed made a mistake thinking inflation was going to be transitory, which it was not. It reacted way too late, so now the United States has inflation that’s the highest in 40 years.

And once the Fed finally stepped in to combat inflation by raising rates and tightening the money supply, its actions caused both the bond and stock markets to tank. It has also led to an inversion of the yield curve, with shorter-term bonds paying higher yields than long-term bonds.

A combination of unforeseen factors led to inflation and the flagging economy. The COVID-19 pandemic, supply chain issues, a very accommodative Fed policy, billions of dollars in stimulus payments, and the Russian invasion of Ukraine have all been shocks to the economy. This was a period of unprecedented developments, and they weren’t the type of fiscal or monetary actions you would see in a normal economic cycle.

Of course, the big question on everyone’s minds is: when will inflation begin to decline? The expectation is we’ll reach a peak in inflation later this year. In fact, we’re seeing it gradually slow down. But the wild card is commodity prices that are holding the economy hostage. Fuel prices will be a big factor, and food is the other key issue because Ukraine and Russia had been major food suppliers.

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The second challenge facing the markets and the economy, following inflation, is the threat of recession. While inflation, rising interest rates, and an inversion of the yield curve are often precursors to a recession, it is not a foregone conclusion. That’s because household balance sheets are solid, employment is strong, corporate earnings are good, and there are no large structural imbalances in the economy.

And while projections for a recession have been all over the map, the median range of projections has been about a 30–50% probability, but our experts think it’s at the lower end of that range. They point to the strong consumer and business balance sheets, rising corporate earnings, and full employment as reasons for optimism.

In addition, earnings have been very strong all year. And as a result, expectations are that stocks may perform better than many market analysts have projected. Plus, stock valuations, which had been relatively high, have fallen during the recent market sell-off, and are now in a more normal range.

Will these factors be enough to hold off a recession? Only time will tell.

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The third challenge facing the markets and the economy is the bear market and the potential for recovery. Not surprisingly, the duration of a bear market tends to be much shorter if the economy doesn’t go into recession. Once the bear market has been reached, the average performance has been good over the following 12 months, and the loss probability is fairly low.

One thing to note: if you are underweight equity as the markets decline, if you keep rebalancing your portfolio, it should be effective over the long term. Some of the biggest upward rallies tend to be during bear markets, so you want to be there when those rallies happen.

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The fourth challenge facing the markets and the economy is volatility. Paradoxically, during periods of volatility good news can be seen as bad news and vice versa. For instance, a strong employment report can stoke fears that the Fed will take more aggressive action to raise rates – and as a result, stocks may go down.

Then if some bad news comes up – such as a weak economic forecast or a decline in stocks – and investors get optimistic about a soft landing, we may see stocks go up, and the cycle repeats. Because of this, we’re going to see continued volatility, with a back-and-forth between growth and value.

The question remains, however, when will volatility subside? Most likely volatility will ease once inflation is under control – even if it is still high. It appears that the Fed is going to be hawkish for a while, but once the market believes that the Fed actually has started to get inflation under control, good news will again be good news and bad news will be bad news. We look at that to be the indicator that we’re back onto this economic cycle, followed by the opportunity to see some quality growth names rebound.

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The fifth challenge facing the markets and the economy is interest rates. With interest rates on the rise, how should fixed-income investors approach the market?

One area both Lowe and Royal like is municipal bonds as their yields look good relative to taxable issues. They feel it would take a very deep recession to affect municipal bonds because they’re a very high-quality asset class.

In slow economic times, high-yield bonds can face the possibility of default, but that doesn’t seem to be a pressing issue in the current environment. Defaults are a lagging indicator. By the time we see a lot of defaults, we’re usually at the end of a recession. At the present time, defaults are near record lows. There will probably be a slight uptick, but there is no expectation of problems with defaults.

Remember, there are some positive aspects to the rising rates. Royal says he would rather have a 10-year treasury at 3.5% rather than 1.5%. Because, all things being equal, higher rates are better for financial companies – rising rates will make the company’s finances stronger.

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The sixth challenge facing the markets and the economy is real estate. With mortgage rates rising, the housing market is cooling off. But there are some promising areas in the real estate market. Royal confirms he is feeling quite good about real estate. Currently his team is underweight in office space, but is overweight in areas like industrial, warehouses, and multi-family – sectors that are less affected by the rising rates.

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As the old saying goes, challenges are opportunities in disguise. In terms of asset allocation, Lowe reports a close to normal allocation: modestly overweight equities, and overweight domestic. Once we feel comfortable that inflation is nearing its peak, we’ll add some risk via more equities. Domestically, small caps are getting interesting, but we’d like to see them come down a little more.

Royal added that he wouldn’t be a seller of equities now. Growth is getting cheaper. There are some great quality companies with strong earnings growth rates that are down 50 percent. Personally, he likes the small- and mid-cap growth space that have been hit the hardest. He would look at mid-cap first since it is a little less risky in this environment. He also likes the large-cap growth space, and some of the big tech names.

Lowe believes the market could go lower if the economy goes into recession, but he still cautions investors against selling stocks at this point. Of course, a lot of it depends on the investor’s time horizon. He believes that we’re at levels now where the probability of long-term gains is quite high.

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Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. We’d like to hear from you! If you’ve got questions or comments about this episode, or if you have an idea for a topic, email us at podcast@thriventfunds.com. You can also learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.

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All information and representations herein are as of June 21, 2022, unless otherwise noted.

Past performance is not necessarily indicative of future results.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.