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The Ugly "R" Word

I hope you've had a wonderful 4th of July holiday week so far. It is by far one of my favorite holidays as I thoroughly enjoy the camaraderie displayed in the parades, the gathering-of-all for the cookouts, and the child-like excitement of watching fireworks light up the evening sky. And to top it off this year, the three-day weekend was a very welcoming reprieve given the turmoil in the financial markets. Now with a belly full of BBQ and root beer, it is time to get back at it and tackle the second half of the year.

SIDE NOTE: DelosCA's Quarterly Reflection will be published the week of July 11th.

During our Coffee with Andrew today, we will discuss The Ugly "R" Word: recession. Over the last few months, we've seen a dramatic increase in recession statements as many have come to realize that the economy may not be as strong as previously thought. The worst equity performance in 50 years stemming from one of the fastest increases in market rates over the last few decades has amplified one of the worst sentiment backdrops in history. Inevitably environments such as these usher in the discussion of recession probabilities, and rightfully so.

One of the biggest debates occurring is the possibility of the U.S. economy entering a recession. The chart above shows the number of stories that contain "Recession" in the title. While the number of stories has increased since the beginning of the year, the last couple of weeks have seen a surge in story count as many have begun to determine if the Federal Reserve will tighten policy too far in order to achieve price stability. Furthermore, the recent bout of economic reports has begun to show signs of meaningful deceleration in economic activity which is further fueling the recession debate.

Now I will be the first to tell you that timing a recession is particularly challenging based on the National Bureau of Economic Research (NBER) definition of a recession, and that the components that derive the recession assessment are coincident and lagging in data. Firstly, most individuals for some reason have been programmed to think that a recession is two consecutive quarters of negative GDP growth. This is incorrect. The NBER defines a recession as a significant decline in economic activity lasting over a few months. The pure vagueness surrounding the duration criteria of the NBER definition makes it challenging to ascertain the official commencement. Secondly, the components that the NBER uses to determine a recession are changes in real personal income, nonfarm payrolls, real consumption, real manufacturing sales, and household employment, all of which are coincident or lagging data points. Therefore, the economists that use these data inputs typically announce the onset of a recession after we’re already well into one. The chart below shows the median and mean forecasts for Real GDP (GDP adjusted for inflation) for the remainder of 2022 and fiscal year 2023.

The NBER components, being coincident and lagging in nature, is what have spurred the debate over the possibility of a recession occurring. Keep in mind that these data points have yet to enter contraction territory which in itself is causing the great divide in the recessionary debate. With that being said, we do not believe we are currently in a recession based on the actual NBER recession and components, but we do believe the probabilities are rapidly increasing for a recessionary environment quicker than most anticipate (based on the prior Real GDP estimate chart). As readers of our work know we have been vocal about the impending slowdown since last year as the rapid rise in inflation and interest rates would soon become a headwind for economic growth. The chart below is our DCA Stress Composite which is financial asset proxies to measure inflation and interest rates regressed against economic growth. What we can see is that the magnitude of the last 12 months' rapid rise in interest rates and inflation has placed leading data on a path to contraction territory. As leading economic data, such as PMIs, continue to decelerate towards contraction, we begin to see peak profit margins which lead the way to cost controls which can come in the form of reduced labor demand and ultimately layoffs.

Over the last few months, we’ve already begun to see labor demand contracts via the ISM PMI Employment subindex alongside a rise in initial jobless claims, both of which are leading economic data. See the chart below. Evidence was driven further this morning with the Challenger U.S. Jobs Cut data reporting at the highest level since December 2020.

The Ugly R Word is never a fun topic to discuss but recessions are an inevitable occurrence within a business cycle. While it sounds counter-productive, recessions clear excess demand which in turn helps reduce inflation across the spectrum of economic inputs. By monitoring leading economic data, we can adjust our Market Model asset allocation to the prevailing economic regime. Backdrops such as today’s environment have dictated not only a defensive posture but patience. One of the most important lessons I have learned when studying the most successful investors of our time is that their accomplishments (wealth) were built by mitigating bear markets and attacking bull markets. Recall that wealth is created at the depths of economic lows as forward returns are the best in a recovery regime. DCA Investment Committee has generated cash equivalents in late 2022 in preparation for our current environment which has allowed us to not only manage 2022’s historic drawdown but give the ability to deploy fresh capital at discounted values. The next phase of this business cycle will be profit misses and/or lower profit guidance in this upcoming quarterly earnings season. It will then be followed by a quicker deterioration in labor conditions which at that point will cause the Fed to pivot thus creating a bottom in economic conditions. Given how quickly this has unfolded, we expect this cycle to flush through at a much faster pace than we have seen in previous cycles. We are monitoring our data models closely. One of the most important things to do during these environments is to review your financial plan, specifically your ability to quickly access liquidity buckets. Times of financial and/or economic stress can occur during recessionary environments so having the ability to utilize risk control assets to fund lifestyle expenses will reduce wealth volatility. DelosCA’s financial planner, Thomas Keeling, will be publishing a thought-leadership piece in our Quarterly Reflections discussing financial planning advice in times of recessionary environments. Please do not hesitate to contact me with any questions or comments. Best, Andrew H. Smith Chief Investment Strategist

DISCLOSURES This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation, and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to Delos Capital Advisors). All information and opinions as well as any forecasts, estimates, and market prices indicated are current as of the date of this report and are subject to change without notice. In no circumstances may this document or any of the information (including any forecast, value, index or other calculated amounts ("Values") be used for any of the following purposes (i) valuation or accounting purposes; (ii) to determine the amounts due or payable, the price or the value of any financial instrument or financial contract; or (iii) to measure the performance of any financial instrument including, without limitation, for the purpose of tracking the return or performance of any Value or of defining the asset allocation of portfolio or of computing performance fees. By receiving this document and the information you will be deemed to represent and warrant to Delos Capital Advisors that you will not use this document or otherwise rely on any of the information for any of the above purposes. This material may not be reproduced, or copies circulated without prior authorization of Delos Capital Advisors. Unless otherwise agreed in writing, Delos Capital Advisors expressly prohibits the distribution and transfer of this material to third parties for any reason. Delos Capital Advisors accepts no liability whatsoever for any claims or lawsuits from any third parties arising from the use or distribution of this material


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