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MCM Insights


Best Case for 2023: A “Rolling” Recession

2023 Planning & Wealth Management Outlook

Last month, I attended Schwab’s annual adviser conference in Denver and heard Chief Investment Strategist Liz Ann Sonders speak extensively on the best case for the US economy in 2023: a “rolling” recession. Sonders believes the recession has already arrived (in some form), and although inflation is red hot, the depth of the downturn has been relatively mild, so far. Stress cracks, however, are starting to emerge, and all eyes are still focused on the Fed’s action and their ability to usher in a “soft” economic landing. If this “rolling” economic pattern continues into 2023 and the labor market stays strong, investors could breathe a sigh of relief.

What is a “rolling” recession?

A rolling recession simply means there are varying pockets of the economy and the strong offset the weak. Similarly, certain countries buoy underperforming ones, limiting the impact of a widespread global recession. Housing, consumer confidence, CEO confidence, goods-oriented sectors (evidenced by rising inventories and slowing sales) and the inverted yield curve (relationship between bond yields and maturity) have already entered recession territory, but there remain strong points like household balance sheets, the resilient labor market and the services industry (such as travel and leisure). This recession is rolling through different parts of the global economy at different times, in contrast to the everything-everywhere-all-at-once recessions exhibited in 2008-09 and 2020, and the impact thus far has been subdued.

The areas that saw the biggest surge during the COVID pandemic were also the breeding ground for the inflation problem we are still dealing with – another example of rolling from one economic side to the other. Crypto, SPACs, NFTs, heavily shorted stocks and various Tech names popped in spectacular fashion in 2020, and undoubtedly have experienced deep valuation compression that was necessary on the inflation backdrop. A lot of that speculative excess, however, has not fully filtered over into the other traditional market areas – an important distinction when compared to 1999-2000, when the speculative excess was concentrated in major areas market and caused widespread impact.

How many more times, Fed?

The post-pandemic global economy is proving perplexing for market strategists, economists and central bankers alike and these mixed signals have befuddled the Federal Reserve. The central bank commentary has seesawed between “too much” and “not enough”, when asked about the future of interest rate hikes. Fed Chairman Jay Powell keeps falling in love with words like “transitory” and “pivot” only to discard them a few months later. His latest favorite phrase is “step down”, an illusion to a deceleration in interest rate increases. Fed policymakers have indicated they are looking to an eventual pause in rate hikes, possibly in early to mid-2023, and it is likely the federal funds rate target will remain at its peak, or "terminal," rate for a while. The Fed is trying to thread the needle between slowing growth enough to curtail inflation while at the same time avoiding a recession—a feat known as achieving a "soft landing"—but that's a very narrow opening. Other experts, however, still doubt the economy's resilience and the Fed’s ability (and history). Top economist Mohamed El-Erian and ex-Treasury chief Larry Summers are both concerned the Fed may overtighten the economy into a severe recession, spiking unemployment past 6%, or repeat the “fits and starts” monetary policy of the 1970s that let inflation get out of control.

Cross currents prove hard to navigate

Investors are in the crosscurrents of inflation spikes, rising interest rates, global economic and stability uncertainty, and talk of a looming recession. It is only a matter of time until cracks in the labor market widen and we see a recessionary move up in the unemployment rate. It may seem counterintuitive, but employment weakness would be welcome sooner rather than later, as it would bring the Fed closer to "checking the box" of increasing slack in the labor market—ultimately helping put downward pressure on inflation and allowing the Fed to ease up on the brake it has been applying to the economy. Liz Ann Sonders warned the market would likely be held back early next year by "Fed calls." "For now, a weaker equity market helping to tighten financial conditions (not to mention rein in speculative excess) is a feature of Fed policy, not a bug," Sonders said. But history suggests stocks could be in for a rebound after the Fed stops hiking rates – as long as the economy is boosted by a strong labor market, Sonders said, pointing to recoveries following previous Fed tightening cycles. If a recession is mild and the job market holds up, that could mean a better environment for stocks in the second half of 2023.

Planning for 2023: Focus on what your money can do for you

1.) Watch inflation, but don’t panic. Although inflation can be painful, there are silver linings:

  • Retirees received a sizable cost-of-living increase in their Social Security payments for 2022, and the cost-of-living increase for 2023 is the largest in 40 years.

  • Tax brackets received a boost for inflation, which could mean lower future tax bills.

  • Interest rates on short-term investments and bonds have risen to levels we haven't seen since 2008.

2.) Manage liquidity and shore up your cash reserves

  • Over the past several years, interest rates were historically low and investors were hesitant to consider and provide for their short-term risk capacity. With the return of an actual risk-free rate, investors can feel good about funding near-term spending goals.

Attractive current short term interest rates

  • Shoring up your cash reserves makes your portfolio more resilient. Otherwise, you may be forced to sell stocks during a market decline, thereby locking in losses and undercutting your portfolio's capacity to recover.

  • For non-retirees: set aside three to six months' worth of living expenses in a relatively safe, liquid account (high yield savings, money markets, or short-term CD) plus enough cash to cover any upcoming sizable expenses; for retirees (or soon-to-be): cash reserves should be much larger, ideally two to four years’ worth of expenses.

3.) Plan ahead for taxes – to increase after-tax wealth

  • No one likes taxes, and most investors generally choose to avoid a tax today that they could pay tomorrow. But tax rates are currently close to post-WWII lows, and they're set to rise when the Tax Cuts and Jobs Act (TCJA) of 2017 expires at the end of 2025 (absent further legislation or actions from Congress).

  • Tax planning is a year-round activity. Start with tax-efficient account selection, then taxable brokerage accounts and tax-efficient investing. Then, consider ways not just to defer tax to a future date, but smooth taxes by strategically managing tax brackets each year and over time. You can do this by focusing on where each dollar of income falls into each tax bracket to potentially lower your taxes and maximize your after-tax wealth. Some strategies to achieve this include Roth conversions, tax-gain harvesting, and tax-loss harvesting (including a significant potential opportunity in 2023 to tax-loss harvest once-in-several-decade drops in value in 2022 of fixed-income bond investments).

4.) Assess emotions, and don’t panic

  • Down markets test investors’ emotions. But trying to time the market can set you back significantly.

  • It's helpful to remember, recoveries happen quickly, with the largest rebound often mid-downturn. Picking objectives, guardrails, and portfolios to stick with, not bouncing in and out, will be particularly important in 2023 and for your wealth long-term.

  • A diversified portfolio does not ensure a profit or guarantee against a loss. Rather, it helps mitigate risk and volatility, potentially improving returns over the long-term.

  • Investing when you have long-term objectives in mind is not a short-term game. Without a plan and a commitment to that plan, especially during market downturns or life changes, we tend to act on emotion – and that can lead to regrettable financial decisions, especially in times of stress.

Source data: Schwab Center for Financial Research; Charles Schwab & Co, Inc.; Standard and Poor's; sections are paraphrased from direct commentary and quotes owned by Liz Ann Sonders, Charles Schwab Institutional


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