2 Hedges & An Investment For A Likely Recession

“Here it comes, here it comes”

From 19th Nervous Breakdown by the Rolling Stones

In this article I will start by discussing why the risk of a recession in the next 12-18 months is increasing rapidly and is now elevated. Then, two hedges and one investment for a recession scenario are presented.

The Economy is Slowing and Americans are Concerned

Google searches for the word “recession” have jumped in the past three months. Americans have clearly become increasingly nervous about a possible recession. How, suddenly this has happened should be alarming.

Experts are getting alarmed too. On Face the Nation on May 16, 2022, Goldman Sachs CEO Lloyd Blankfein said there is “a very, very high risk factor” that the U.S. is headed for a recession as the Federal Reserve tightens policy to tackle high inflation. “If I were running a big company, I would be very prepared for it. If I was a consumer, I’d be prepared for it,” Wells Fargo CEO Charlie Scharf also expected a recession in a WSJ article dated May 18, 2022.

The chart below shows increased negativity about corporate earnings by fund managers.

There are a number of headwinds aligning that are causing this fear which will be discussed in this article. Everyone knows about interest rates and inflation, but there is another economic headwind as powerful if not more powerful. It is pulled forward demand caused by excessive stimulus. Pent up demand has gotten us out of every recession. It is a very powerful economic force. Pulled forward demand is the opposite of pent up demand, usually leads to declining demand after a short surge. More on this below.

A number of economic reports are showing a slowing economy including the two below. The surprise index below shows whether economic announcements are beating or missing economist’s expectations on average.

The stickiest inflation is labor inflation. Labor inflation is starting to ease as shown below.

Emerging Headwinds for Stocks

The economy has suddenly run into a number of headwinds. These headwinds are already slowing the economy and risk putting it into recession if they continue for much longer. Ten are listed and discussed below.

1. Inflation – Prices for rent, energy, home purchases, commodities and food are all way up. Inflation is now significantly exceeding wage gains resulting in the average consumer losing ground. Gasoline and food prices in particular are having a major impact on low to moderate income people. Home prices are impacting everyone. High inflation is a direct result of historic levels of stimulus poured into the economy by the Federal government and the Federal Reserve.

2. Interest rates – Fed Funds which were effectively close to zero a few weeks ago are now expected to be close to 3.00% in a year by the futures markets. They are needed to fight inflation. Historically, rising oil prices combined with tighter monetary policy (the Fed raising rates) have preceded recessions as shown below.

3. War in Ukraine – This has significantly increased certain commodity prices, and added uncertainty regarding cyberattacks, and possibly nuclear attacks.

4. Demand pulled forward – The massive fiscal stimulus resulted in a consumer spending surge unlike any we have ever seen. Many brick and mortar retailers near insolvency in 2019 have come back strong. But history shows consumer stimulus not only doesn’t last, it often leads to a pullback once gone. The government had three consumer stimulus programs in the 2007-2009 recession. All three ended up pulling forward demand resulting in a large drop off. The first stimulus was the tax refunds (stimulus checks) in the summer of 2008. The economy fell off a cliff immediately after these refunds stopped. The next large stimulus was housing tax credits. These drove up home sales a bit and slowed the decline of home prices. Once the tax credits ended, home sales resumed their decline at an even faster rate. The government also tried “cash for clunkers” to stimulate car sales. Automobile purchases immediately returned to their former depressed rate once this stimulus ended. We are now seeing the end of benefits from the massive stimulus poured into the economy as shown below. Pulled forward demand is magnified now as the recent stimulus was well above anything seen in 2007-2009.

5. Stimulus fade – The stimulus checks sent to consumers ended a year ago and the impact continues to fade as shown below. As that happens, it turns from a tailwind to a headwind to the economy.

6. Consumer sentiment – Changes in consumer sentiment often translate to changes in economic activity. As shown below, it is dropping rapidly currently. The University of Michigan Consumer Survey is shown below. It is at record low levels and declining. Consumer sentiment change often precedes changes in consumer spending levels. Business sentiment is also falling which usually leads to less capital investment.

7. IPO and secondary filings much lower – Investors are suddenly much less willing to finance the losses or growth of money losing companies. Less investment usually means less economic activity. Both IPO and secondary issuance activity are way down over the past two months.

8. Corporate demand warnings – For the past year, companies almost exclusively spoke of strong demand in their conference calls and earnings reports. The problem was meeting demand due to supply chain issues. They are suddenly starting to warn of weak demand again.

9. Housing starting to slow – The housing market has been a big boost to the economy the last two years. But higher interest rates and large price increases have made homes less affordable. On May 18, 2022, it was reported that new mortgage applications for purchases were down 11.9% from the prior week. Higher prices will also impact the rental market.

10. Strength of the dollar – A surging dollar is being caused by U.S. interest rates rising faster than international ones. This feeds inflation and makes U.S. manufactured goods less competitive.

Tailwinds

It’s not all doom and gloom. There are several tailwinds holding up the economy. Consumers are still sitting on much more cash and investments than they did before the pandemic. This can be used to sustain spending levels. Consumer spending remains quite strong to this point. Supply chain problems should eventually get worked out. As they do, that makes the economy more efficient and lowers costs and inflation. A number of workers have not yet re-entered the workforce they left after the pandemic started. As they do, it will add to wealth and business capacity. The unemployment rate is just off a record low level making getting a job the easiest it has been since World War II.

Two Hedges and an Investment

For those seriously concerned about a recession here are two hedges and one investment to consider. There is no perfect hedge for a recession, as no two are the same. But these should have a better inverse reaction to one than most others. I have a position in each.

1. Go Long Fed Funds futures

Did you know you can buy Fed Funds futures contracts on the CME? If you go long Fed Funds futures, you are betting on Fed Funds rates being less than what the futures market expects. Why is that important? Well, if we have a recession, it is highly likely to reduce inflation to normal levels or even less. The Fed is raising interest rates, to kill inflation. They will stop raising rates if inflation falls off. Recessions historically kill inflation.

Fed Funds Futures for late 2023 and early 2024 currently are trading at about 96.90. The price is the inverse of the rate. So that means the market expects the Fed Funds rate to be 3.10% in late 2023 and early 2024 (the formula is 100 – 96.9 = 3.10). If you expect the Fed Funds rate to be lower than 3.10% go long Fed Funds futures of that time period.

Here’s the math, and its important. Each basis point (a basis point is 0.01%) move in fed Funds futures is a $41.67 increase/decrease per contract. The important thing is to calculate how much exposure you want. Remember, you can lose a lot of money on this transaction if rates go the wrong way. So, I don’t recommend exposing yourself more than you need to provide a partial hedge for your portfolio.

My recommendation is to go as far out as possible. The market is expecting the Fed Funds rate to get to 3% by the end of 2022, then flatten out. Right now, the farthest out active Fed Funds futures are late 2023 and early 2024. The economy has been quite strong the past year, though it slowed in the first quarter. Going out farther gives the economy time to falter, forcing the Fed to stop raising the Fed Funds rate. That gives your hedge time to work. Unlike options, there is no time premium or cost to go out longer.

I also strongly urge you look at how much you can afford to lose if we are wrong about a recession happening. Keep in mind, this should be a hedge, not an investment or bet. As a hedge if the economy stays strong, you are likely to more than make up your Fed Funds futures losses elsewhere.

2. Short the SPDR S&P Retail ETF

This is also a hedge. Remember how I spoke about the massive stimulus pulling forward demand? Nowhere has that had more impact than with retailers. There were a number of them near failure just before the pandemic. Almost all were given a new lease on life by the spending derived from stimulus checks. Many others have had huge and unsustainable revenue and profit margin gains. The chart below shows a massive rally starting in mid-2000 for a sector that had previously been quite flat for years.

Consumer spending remains strong at this point, but retailers are starting to see a slowdown. Lowe’s reported a 3% year-over-year sales decline on May 18, 2022. TJX reported the same day and now only expects a 1-2% revenue increase this year.

Reversion to the mean is one of the most powerful economic forces. The chart below shows consumer spending has been well above average since the stimulus started.

The beauty of this short position is not only do you benefit from the usual drop in a recession (retail is very cyclical), you also benefit from a further even larger drop since this index is still way above what was normal pre-pandemic. It is currently trading at $68. It could easily drop to $30 in a recession.

3. Buy JPM Preferred Stock Series MM (JPM.PM)

For an investment that should work well in a recession take a look at these. You get a 5.68% yield plus probable eventual appreciation of 30+%. This security was issued in July 2021 at the usual par price of $25 per share. You get a $1.05 (annually) coupon until at least September 2026. It is currently trading for $18.88. So just going back to par is a 32% return, plus the dividend. The price has dropped due to the rise in interest rates. So, this is like the Fed Funds hedge, you are betting a recession will lower interest rates. However, its much safer than Fed Funds futures which is why I look at this as an investment, not a hedge.

Other banks, such as Wells Fargo have similar preferred bargains right now. Why buy a bank security if you expect a recession? Banks are much more strongly capitalized than they were in the mid-2000s recession and have less risky assets. Regarding JPM specifically, Jamie Dimon is known as being a very good risk manager. With no call for four more years, that is more than enough time for rates to come down.

4. Positioning Your Portfolio

In addition to these options consider the following. Start buying bonds again. TINA (There is no alternative to stocks) is dead. I recently wrote a whole article about this titled The TINA Era is Over: Time To Buy Bonds Again

Ten-year BBB rated bonds are yielding 4-5.5%, up from 2-3% last year. Some A rated 10-year bonds are now over 4%. Time to lock in these yields as we may not see them again after 2022 for quite some time.