Investors should keep recession in back of mind

As central banks push rates higher to combat inflation, a Los Angeles-based portfolio manager is skeptical that the Fed will avoid causing a recession.

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As a result, investors should keep recession “in the back of [their] mind” as they manage portfolios, said Samuel Lau, a portfolio manager with DoubleLine Capital in Los Angeles.

U.S. inflation jumped 8.5% in March for the sharpest year-over-year increase since December 1981. “That spooked the Fed into pivoting towards an aggressively tighter monetary policy,” Lau said in an interview last month.

And while some indicators point to inflation nearing its peak, Lau predicts that it will likely remain well above the Fed’s target core inflation rate of 2% for a number of years yet.

Annual inflation slowed to 8.3% in April, and the month-to-month increase of 0.3% was the smallest in eight months.

The Federal Reserve has responded to rising prices with more aggressive monetary policy, hiking its key rate by a half point earlier this month.

What gives the Fed optimism to hike rates and unwind its balance sheet, Lau said, is the strength of the U.S. economy and labour market.

Economists’ forecast for real GDP growth in the U.S. this year is just over 3% on an annual basis, he said. The jobless rate is historically low at 3.6% and the Atlanta Fed’s Wage Growth measure is at its highest since the late 1990s.

“The Fed thinks the U.S. labour market is resilient enough to support the economy as it looks to dampen consumer inflation without sending the U.S. economy into a recession,” Lau said.

Further, the Fed has offered a glimpse into its plan for future hikes and quantitative tightening. The market is expecting a “fast and furious” hiking cycle and a much faster reduction in the Fed’s $9-trillion balance sheet, Lau said.

That’s a much more aggressive approach than the last Fed tightening cycle in 2015, when the central bank took three years to reach an upper bound of 2.5% in 2018.

Ultimately, an aggressive rate hike cycle coupled with a potentially faster unwinding of the balance sheet speaks to the question of whether or not the Fed can orchestrate a soft economic landing — one where rising rates don’t lead to a recession within six quarters of the last hike.

“Maybe,” Lau said, “but it doesn’t look very promising.”

Of the nine rate hiking cycles since 1971, seven led to a recession, he said. “So the Fed has successfully avoided recession two out of nine times.”

However, Lau isn’t calling for a U.S. recession now. The Fed has only started its hiking cycle, and recessions generally don’t occur until the Fed has reversed course and starts cutting rates, he said — once they realize the economy can’t absorb the higher rates.

“But what I am saying is that perhaps recession should be in the back of your mind as you consider your portfolio allocations and assess how they may perform in a slowing economy,” he said.

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