Index Decline Undermines Investor Expectations

The Conference Board’s Leading Indicators Index change for April is negative. That makes 13 months in a row. As discussed in their May 18 report, the decline’s depth is now signaling a coming recession – likely in 2023.

The question is, will it happen, or are today’s unusual conditions producing a false warning? After all, the Fed apparently is willing to cease interest rate increases for now. Also, the stock and bond markets are generally stable. Therefore, perhaps it’s time for other leading indicators to stabilize as well.

The catch – There are other negative issues at work

The downer effects from the higher interest rates are only partially complete. Examples are commercial real estate difficulties, credit rating drops and future refinancing needs. Also, there are signs that consumers are making inflation-driven spending adjustments as companies use price increases to maintain profits (albeit reducing unit sales).

The problem is such a pricing strategy is only a short-term cure. As inflation continues, additional price increases will begin to produce harmful effects. That’s when companies will turn to significant cost cutting – and that means layoffs and higher unemployment claims (the one leading indicator not yet exhibiting weakness).

Moreover, if the higher-than-desired inflation rate continues, it likely will push the Fed into a new interest rate-raising phase. While the current 5% short-term interest rate is near the 5% inflation readings, that makes the “real” (inflation-adjusted) rate only 0%. In past inflation-fighting periods, real rates needed to be pushed above 0%. If that happens, expect long-term yields once again to rise (bond prices to fall), stock prices and real estate values to weaken, and economic growth to slip further – perhaps into negative (recession) territory.

Remember the wealth effect?

When valuations were rising, the wealth effect was viewed as an important driver of spending growth. Unfortunately, the wealth effect also works in reverse. When consumers’ investment and real estate values shrink, confidence weakens and spending slips. Add in rising costs, and consumers turn cautious. That is where we are now, so those hopeful outlooks regarding the Fed, Wall Street, interest rates and company results could be markedly premature.

The bottom line – Focus on safe 5% yield

Doing so makes any risky investment have to prove itself with an appropriately higher return potential. Historically, asset allocation (portfolio) analysis was based on three factors: real returns, risk levels and correlations (i.e., diversification benefits). In general, “cash” (a safe investment of a 3-month U.S. Treasury Bill) was expected to yield a 0% real return (like today’s 5% interest rate minus the 5% inflation rate). Moving to a diversified bond portfolio (with maturity and credit risks), a real return of about 2% was viewed as appropriate. As to a diversified stock portfolio, a real return of about 6% was considered appropriate.