We sat down this week with John Slavic, CEO and Founder of Slavic401k, to hear his thoughts on the current state of the market, interest rate hikes, and a potential recession this year. Read on to gain a better understanding of what has led us to this point, and how to navigate the choppy waters ahead.
Q: Are there economic and market indicators of a recession?
There are several economic indicators that a recession will likely take place sometime next year, especially with inflation at 8.5% — the highest since 1981. The response of the Federal Reserve is to do two things. First, to raise interest rates. There is an expectation built into the stock market that the Fed will raise interest rates substantially and more aggressively than originally thought. Second, they are eliminating quantitative easing to stifle the inflation spike. Whenever that has happened in previous periods it has ushered in a recessionary period. You can even look back to the 1980’s under the Reagan Administration. Fed chairman Paul Volcker raised interest rates aggressively and it immediately thrust the economy into a recession. Probably the most vivid in our memory is the recession of 2007-09 with the housing crisis. Interest rates were raised during that period forcing the economy into a recession due to the rapid deterioration of the housing market.
The market indicators are pretty interesting at this stage. Part of the reevaluation that’s taking place in the stock market is the multiple that is put on a stock right now. For instance, the average multiplier right now in the S&P 500 is 18. It’s trending down to 16 which would be a historically low valuation multiplier as it pertains to stock prices. When you see a disinflationary move like this in stock prices, that would typically portend a recession probably sometime next year.
The final indicator (which only happened briefly) is the inverted yield curve, which is when interest rates paid by two-, five-, 10- and 30-year treasury bills becomes inverted, with the short-term rate being higher than the long-term rate. Whenever that inversion has taken place historically, 100% of the time, there has been either a slowdown in the economy or an outright recession.
These are the economic and market indicators that I think are important for us at this stage.
Q: Historically, how long do recessions last?
That’s a little hard to say. There was a very brief recession in 2001 after the devastating events on 9/11. The tech bubble burst, plunging valuations on technology companies, many of whom went out of business. Well-known companies such as Microsoft, Apple and Intel suffered during that recessionary period as well but came back to dominate the market in later years.
Typically, when a recession is induced by interest rate changes it will be a longer recession, but less deep. Alternatively, we had a deep recession in March 2020 right at the onset of the pandemic and the shutdown of the economy. As that recession was commencing, the Federal Reserve stepped in, lowering interest rates and injecting money into the economy. Hence, a brief recession. Following the mid-term elections, I would expect government policy to shift from an ultra-high spending approach to a much more conservative approach.
These are factors that would be in play not only for the recession occurring, but also for the length and depth of the recession.
Q: What can the average consumer expect?
Consumers are feeling inflation firsthand. From the grocery store to the pump, consumers have seen a significant increase in prices. For example, you are probably paying close to $5.00 a gallon for gas (or more), compared to $2.50 – $3.00 a year ago. That is a remarkably important change for the consumer.
The other thing that is affecting the economy is the labor shortage. Wages have spiked somewhere between 20-40%, particularly in quick serve restaurants, hospitality, and retail sectors. That has put a great deal of pressure on businesses to raise prices. Many businesses don’t have a wide enough profit margin to be able to absorb the high labor costs, forcing them to downsize or to shut their doors altogether.
Q: With inflation, rising interest rates, COVID-19, the housing marketing, and now a possible recession, what does this mean for the overall economy?
We can expect a slowdown and possibly a recession. In many respects, the backbone in the economy remains relatively strong during this adverse period. Many companies have flourished in this type of environment while many others have floundered. As we go forward, we will see a reordering in the economy. Some companies will do very well, while others will do poorly. The pace at which this normal change occurs has just been accelerated because of current conditions. We shouldn’t expect bailout dollars to get through this period or a lowering of interest rates by the Federal Reserve. This is also where we will begin to see the real business fallout from the last couple of turbulent years. Housing prices are peaking or close to peaking at this stage. Further, as affordability of houses has declined so substantially that the demand is also falling. So, the supply and demand for housing is another critical factor.
Q: How does a recession affect retirement savings?
It’s very difficult to predict how the economy and the stock market is going to react. In terms of investing approaches, we rely heavily upon index funds for two reasons. First, index funds are among the lowest cost investment vehicles available to a 401(k) participant. Second, the indexes change over time. The best example is the S&P 500 index which takes into account the top 500 companies traded in the stock market and is updated several times per year. As poorly performing companies fall out of the top 500 category, other companies that are flourishing, enter. The constant rotation of companies makes it difficult for the average stock picker or investment advisor to beat the return in the S&P 500. At Slavic401k, we use index funds in our managed portfolios, so we are able to calibrate the risk exposure for the participant. Consequently, if that risk exposure is correctly calibrated to the age, financial objectives, and other financial factors, then the best retirement savings approach is to stay the course.
Sometimes it’s difficult to continue investing money into your account during a recessionary period when the stock market is down. It feels as if it’s good money after bad, but it’s not. What you are actually doing is accumulating more shares of the various fund components that comprise your portfolio. While your account value may be lower, you’re accumulating a much larger number of shares, so that eventually when the stock market begins a recovery, you have a much broader base to move higher. As a result, the stock market might produce a 12 to 15% return in that same period because of the dollar cost averaging approach associated with continuing to invest during difficult periods.
Q: Is it a good time to reevaluate portfolio and risk levels?
Yes, but do it carefully. That reevaluation means if you’ve lost a bunch of money and you are concerned with continued losses, then the hard answer here is that you should have reevaluated earlier. The problem is that if you reallocate during these down periods into a much more conservative position, when the market eventually does recover, you’re going to miss those upside returns that would normally be accrued in a disproportionate way. In other words, if at this stage you were to lock yourself into a much more conservative allocation, you would also be locking in those losses. For that reason, it’s important to not have an emotional and/or fear-based response to market downturns, like the one we are experiencing currently, but to be able to weather them with a long-term view towards your future.
The commentary and market insights provided by John Slavic are for informational purposes only and do not guarantee future results.