“You Better Brace Yourself”

These were the words spoken by JPMorgan CEO Jamie Dimon at a recent financial conference. Mr. Dimon warned of an economic “hurricane” on the horizon, largely due to the Federal Reserve (the “Fed”) shrinking its balance sheet in response to high inflation (i.e., “quantitative tightening”), and the impact of the Russia-Ukraine War on commodities, including food and energy. 

Whether or not the U.S. economy will enter a recession seems to be dominating the discussion on Wall Street these days. Some analysts and prognosticators see no recession in sight, while others think it is inevitable, or that the recession may have already arrived. The likelihood of a recession seems to be increasing, as the Fed recently raised interest rates by 75 bps, the largest increase since 1994, and Chairman Jerome Powell has indicated they will remain aggressive to tame inflation. In addition, higher food and energy prices seem likely to persist due to supply-related issues, and are therefore mostly outside of the Fed’s control. Finally, these price increases for necessities will likely force consumers to cut back in other areas, as we recently saw with the disappointing May retail sales.  

While we cannot predict exactly when or even if a recession will occur, there are reasons to think that a possible recession may resemble more of a mild storm than a hurricane, and that it may not lead to the severe economic and market dislocations experienced during the Great Financial Crisis (“GFC”). The U.S. economy is near a historically low unemployment rate as a starting point, and there are over 5 million more job openings than job seekers. There is a shortage of inventory for housing and autos, rather than the excessive inventory levels that tend to be associated with deep bear markets and severe recessions. There does not appear to be a particular area of the market, such as sub-prime mortgages during the GFC, that stands out as potentially causing a systemic threat to the banking system. And while low interest rates and government stimulus have contributed to the creation of asset bubbles in areas such as crypto, NFTs, and unprofitable high-growth companies, many of these assets have already traded down 60-80% from their peak.   

The main question on investor’s minds is how a potential recession may further impact their portfolio after a difficult start to the year. A recent article in The Wall Street Journal noted that of the 12 recessions that have occurred since World War II, the median corresponding decline in the S&P 500 was 24%, a level that was nearly breached in recent weeks. The stock market also tends to be 12 or more months ahead of the economy, and in many past cycles much of the stock market pain was already felt by the time investors realized the economy had entered recession and earnings revisions for companies started to decrease. 

Are we at the beginning of an economic hurricane? No one knows for sure. However, given the current backdrop and history of past cycles, the storm that has already been brewing in the stock market over the past six months may be closer to the end.

All comments and suggestions are welcome.

David Drogheo, CFA