Investing for a Soft Landing or Recession

Telemus Weekly Market Review July 17th - July 21st, 2023

Following softer than expected inflation data in June, the debate around the prospect of a looming recession versus a soft landing has intensified. The data from June clearly provides hope that the Federal Reserve can keep the economy growing, unemployment low and inflation in check. However, June is just one month worth of data. Moreover, the Fed did embark on its most aggressive rate tightening in forty years and the impact of those rate hikes has yet to been fully felt throughout the economy. Predicting what inflation levels will be in the months to come and how quickly unemployment levels will rise from their recent 50-year low is not something anyone can forecast with precession. So how do investors position portfolios around such lack of certainty? 

To answer the question, we must first consider what might happen in both a soft landing and a recessionary scenario. Considering what translates through the economy will help assess how corporate fundamentals may evolve.  

In a soft-landing scenario where the U.S. economy skirts a recession, it is likely that the Federal Reserve will need moderate any adjustments to its policies. If inflation is near its 2% annual target, then technically the Fed can feel free to adjust rates lower. However, the concern in this scenario is a rebound in the economy that sets off another inflationary cycle. This is what transpired in the 1970’s where there were three separate bouts of inflation, each one greater than the previous. Therefore, in a soft-landing scenario, the Fed likely keeps rates higher than many expect them to with more gradual reductions. This will lead to more constrained availability of credit. Mortgage rates will remain high, serving as a governor to a more pronounced rebound in housing. Lastly, corporations may limit the amount of capital expenditures they put into their business given higher borrowing rates. Overall, we would expect a soft landing to have the outcome of slower, more constrained economic growth. 

What investments would work in this environment? Those that are less reliant on debt financing, which will remain more expensive. Those businesses that able to raise prices without material pushback from customers. Those businesses able to generate sufficient cash flow to fund growth investments and not be reliant on capital markets to do so. All these traits are indicative of what we’d consider to be a quality company. In investment jargon, quality is a term that can often be defined differently depending on the individual. To us, quality companies are those with limited or no debt, price setters and not price takers, those with high levels of profitability, and those capable of funding the growth in their business through the cash flow they generate. It is these companies that we would expect to benefit in a soft-landing scenario.

Now let’s flip to the other alternative, a recession. Several traditional recessionary indicators still indicate the U.S. economy could be nearing a recession. In this environment, we’d expect a shallow recession given the strength of the labor market, which is likely to lead to fewer layoffs this cycle. Consequently, consumers may elect to spend more than they might otherwise do in a slowing economy given their confidence in employment. Typically heading into a recession, you want to focus on business that are more predictable, have less economic cyclicality and are not reliant on capital markets to fund their business. Hence, heading into a recession one should emphasize quality and lower volatility companies. Heading out a recession, one would want to take more risk and own more economically cyclical companies. However, should we enter a shallow recession, one may not need to be as rigid in owning defensive stocks on the way down and cyclical stocks on the way out. As we look at the market today, what’s priced into stocks is anything but a recession. Economically cyclical industries such as manufacturing, automotive and transportation companies do not yet embed expectations of a slowdown in earnings. Therefore, these companies are likely to face greater declines in the event of even a shallow recession. Quality companies are going to be less sensitive to lowered expectations and will likely hold up better through the initial downturn. Depending on how significant expectations are cut on economically cyclical companies will dictate to what extent these stocks benefit on the upside coming out of a recession. 

It has become a more complex economic environment to analyze as the stimulative fueled excess of the pandemic has skewed conditions to the point where they are anything but normal. However, as we look at both sides of the economic argument and consider how to position portfolios, the refreshing answer is quality companies should hold up well regardless of what scenario plays out. 

All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Telemus Capital cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. Current and future portfolio holdings are subject to risk. Risks may include interest-rate risk, market risk, inflation risk, deflation risk, currency risk, reinvestment risk, business risk, liquidity risk, financial risk, and cybersecurity risk. These risks are more fully described in Telemus Capital's Firm Brochure (Part 2A of Form ADV), which is available upon request. Telemus Capital does not guarantee the results of any investments. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, and may lose value. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products.  The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities.

Advisory services are only offered to clients or prospective clients where Telemus and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Telemus unless a client service agreement is in place.