Hard Landing, Soft Landing, or No Landing at All?
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Equity and bond markets are often impacted by global events and the health and direction of the economy. This has been increasingly relevant over the last few years given the global health pandemic, war in Ukraine, and the highest U.S. inflation in more than 40 years. Recent failures of Silicon Valley Bank and Credit Suisse have contributed to an understandable dip in consumer sentiment. This shaken confidence can lead to increased concerns and fears about what’s to come and cause a ripple effect in investment markets.
While inflation in the U.S. has slowed relative to a few months ago, fears of sustained higher interest rates and, ultimately, a recession are still on the minds of many. Consumer sentiment is near an all-time low. But it is not all negatives ahead, and where markets go from here depends on a few outcomes.
The first consideration is whether there is a hard landing, where the economy experiences a sharp contraction, ultimately leading to a recession. This scenario has been often precipitated by a financial crisis and would result in significant declines in corporate earnings and economic growth, likely pushing interest rates and equities meaningfully lower.
A soft landing is also possible, where the Fed successfully maneuvers the economy into a gradual slowdown, with inflation moving towards the Fed’s long-term target of 2%. In this scenario, rates will likely move sideways or come down slowly and equities could move higher. While this is certainly the most desirable outcome, the deep inversion of the yield curve this year reduces the odds of a soft landing.
A third scenario is no landing at all, where the economy remains relatively strong, inflation remains above trend, and the Fed is forced to hike rates more than expected.
For each of these outcomes, the impact on client portfolios and asset allocation could be very different.
Nobody knows what will happen, but history has demonstrated that when investors have reached low points in optimism about the direction of the economy, stocks have typically ended much higher, on average, just one year later. Additionally, following substantial declines in the stock market (over 25%, peak-to-trough), patient investors have been rewarded with very robust long-term performance in subsequent (three-, five-, and 10-year) periods. History suggests that there is a high likelihood of strong stock performance after periods of market declines, and that recessions ultimately set the stage for the next period of economic growth.
January economic data seemed to give investors more confidence in a soft-landing scenario, though February data caused investor confidence to wane, indicating a more resilient economy and stickier-than-expected core inflation. As we entered March, central bank policy and geopolitical uncertainty were key themes still dominating headlines, with continued concerns over the possibility of a recession in the coming months.
What does all this mean for investment portfolios? Our approach with clients has always been focused on process, not prediction, and reiterating the importance of diversification and a long-term mindset. While traditional stocks and bonds serve an important role within a diversified portfolio, alternative asset classes can reduce volatility and provide a different return stream than traditional asset classes. Inflation-hedging assets like mid-stream energy, infrastructure real estate, and other real assets provided significant downside protection in 2022.
Exposure to high-quality fixed income and cash not only can help provide downside protection during an economic contraction or hard-landing scenario; it also provides income generation in portfolios. Deflation hedges are more commonly found in areas like fixed income and are more attractive now due to the rise in interest rates, especially within high-quality/intermediate and long-term fixed income investments.
The Fed has raised its benchmark rate by 4.75% since March of 2022, marking the fastest pace of rate hikes since the early 1980s. Almost all previous rate-tightening periods have resulted in a financial crisis, and this time appears no different (seen by stress in the banking system).
Economists are debating whether the aggressive action by the Fed will steer the U.S. economy towards a hard landing and ultimately drive it into a recession. As the German economist Rudi Dornbusch said, “economic expansions do not die of old age; they are murdered by the Federal Reserve.” Will this time be any different? Can the Fed successfully bring down inflation without an economic downturn and navigate a soft-landing scenario?
History suggests that this might be difficult, as the U.S. has entered a recession following the last five periods when inflation peaked above 5%. No matter the outcome, clients will benefit from following a prudent investment process that reinforces the importance of asset allocation, downside risk mitigation, and focusing long-term.
Steven Fraley, CFA, MBA, vice president, and director at Innovest, provides consulting services to families. Steven is a member of the investment committee, which drives the firm’s investment-related research. He is a member of the due-diligence group, responsible for independently sourcing investment managers. Steven is also the director of capital markets research group, responsible for monitoring the global macro-economic environment.
Nancy Rimington is a vice president and consultant at Innovest. She provides consulting services to retirement plans, nonprofits, and families. Nancy is a member of the capital markets research group, which is responsible for monitoring the global macro-environment, asset allocation modeling, and portfolio construction. She is also a member of Innovest’s retirement plan and nonprofit practices groups.