The U-Shaped Recovery Scenario

U-Shaped recoveries occur when the economy slows down considerably, and a recession occurs, causing a period of little to no growth for a few quarters.

Examples of U-Shaped recoveries are the 1973-75 Nixon recession and the 1990-91 recession following the S&L crisis. The most recent one was the financial crisis in 2008-2009. We are in the midst of another U-Shaped recovery that will take several quarters to play out.

Global economies are experiencing inflation for the first time since the 70s, and that will take considerable time to reduce some of the cost pressures. Since the financial crisis, we have seen multiple corrections of 10% to 25% but had quickly recovered over a few months. One of the main reasons for this was the highly accommodative Fed that used quantitative easing and low-interest rates to stimulate the economy and support the markets. The Fed has an aggressive posture now that will make it difficult for the market to have any sustained rallies. The only tool the Fed currently has is using higher interest rates. This will weaken the demand side of the economy.

Inflation will have to come down to manageable levels, and industrial capacity will have to loosen to take the stress off supply chains. This strategy is beginning to work, but it has costs. So, for the first time in a long time, this “price correction” in the market will have more “time risk” than we have had in decades.

Our response to the current environment has been to raise more cash to levels of 20% with the notion that the cash will finally be earning a decent rate of return, and the liquidity will give us dry powder to increase risk once the market stabilizes. Stocks and bonds are down double digits this year for the first time in 40 years.

Our fixed income positions are short-term in duration, and we will be increasing our allocation to bonds as the Fed continues to raise the fed funds rate. Ultimately, the Fed will get to the end of this rate hike cycle. In fact, the market (fed funds futures) is already starting to price in rate cuts later in 2023. This should help our bond positions as they have been punished this year as interest rates have risen sharply. Our equity exposure consists of large-cap technology stocks, high-quality growth companies, large cap value, and dividend aristocrats that have predictable and healthy cash flows. In addition, we own basket of commodity companies that have energy, metals, and agriculture exposure.

While we will see a slow down in economies around the world over the next few quarters, we believe that inflation in food and energy will be persistent. The backdrop in food and energy security and production is very challenging which will keep agricultural and oil prices elevated. Lastly, corporate margins will compress as cost pressures increase due to higher wages and other input costs. Increasing productivity and efficiency will be a top priority for every company that wants to protect its profit margins. We have been adding companies to the portfolio that provide solutions through software, robotics, and analytics that will help maintain those margins or at least slow down any potential deterioration to them.

In the meantime, patience will be required as there will be many potential outcomes given the challenges our economy will have to overcome. As active managers, we will be ready to make adjustments as the landscape changes.

Please feel free to call or email anytime with any questions.