Portfolio Construction

Reframing the Recession Debate

July 31 2023

Terry Davis, Director of Investment Solutions

A paradox between market sentiment and portfolio positioning suggests investors refocus on interest rate cycles.

Transcript

Hi, I’m Terry Davis, Director of Investment Solutions in the Portfolio Construction Solutions group here at T. Rowe Price.

In this Portfolio Construction Insight – “Reframing the Recession Debate” – I’ll cover three important topics:

The apparent paradox between negative market sentiment and portfolio positioning in financial professionals’ portfolios
How to reframe the recession debate to focus on historical U.S. interest rate cycles
And finally, we’ll look at some potential approaches to portfolio construction based on prior rate cycles.

First, the paradox.

During 2022, the average financial professional who engaged with us reduced exposure to core bonds and increased short duration and cash positions to defend against rising interest rates. They also increased exposure to real assets stocks to combat higher inflation. Coupled with an increase in alternative positions partially funded from fixed income, these moves have resulted in higher-beta portfolios and increased cyclicality.

As a result, we see increased potential for downside during a possible risk-off environment. This positioning also appears to be at odds with the widely held belief that the Federal Reserve may be nearing the end of the current rate hike cycle.

Second, let’s look at how to reframe the discission.

Investors ask us frequently if we are entering a recession? However, we believe there may be a better way to frame the recession question.

Instead of focusing on a looming recession, we suggest using historical performance during past Fed rate cycles as a guide. It’s important to note that recession outlooks tend to be binary— either we’re in a recession or we’re not.

In our analysis, we looked at historical rate cycles since 1992 and we broke down past Fed rate cycles into three sections: rate hikes, pauses after rate hikes, and rate cuts. It’s important to note that most investors have greater conviction in their interest rate cycle beliefs than their recession forecasting.

In our analysis, we found that rate hike cycles tended to be the longest and last about 14 months on average. We note that the current hiking cycle is as of this recording above the average, but it remains below the maximum cycle length. Rate pauses after hikes cycles average 9 months while rate cutting cycles tended to be the shortest on average — at about 7 months.

Currently, we appear to be nearing an inflection point in the present rate cycle, with the Fed nearing its terminal rate and widely held expectations that a rate pause is on the horizon. When this change eventually occurs, it could offer an opportunity for investors to increase exposure to asset classes that historically performed better during previous Fed rate pauses and/or cutting cycles.

Now, let’s look at some potential approaches to portfolio construction based on performance during previous rate cycles.

During Fed rate hike cycles since 1992, equities and fixed income performance varied widely.

Among equities, growth outpaced value and large-caps beat small-caps.
In the fixed income space, shorter duration and agency mortgage-backed securities tended to perform well.

In Fed rate pause cycles, both equities and fixed income were positive, enjoyed their best performance and there was less dispersion amongst asset classes

Growth equities edged out value but the gap narrowed. Large-caps slightly outpaced small-caps, and international underperformed.
Leadership in fixed income transitioned from short-duration to long duration as U.S. long government debt outperformed, higher credit quality also performed better than lower quality

And finally, during rate cut cycles, equities generally declined and fixed income gained.

Among equities, large-caps outperformed small-caps and value beat growth on a relative basis.
In fixed income, long treasuries performed best, and government bonds, including agency mortgage backed securities, outperformed all other asset classes within each duration bucket. High yield was the worst performing asset class.

If you have questions about how to position your portfolios for a potential change in the Fed interest rate cycle, please visit the T. Rowe Price website and read the full insight, “Reframing the Recession Debate.”

contact your T. Rowe Price Sales representative and set up a consultation with one of our Portfolio Construction Specialists. We’re here to help.

Thank you.

KEY INSIGHTS

The Portfolio Construction Solutions team uncovered an apparent paradox among financial professional portfolios: Negative market sentiment points toward recessionary concerns, but portfolios remain positioned for rising rates and high inflation.
Investing during a period of elevated recession risk can be tricky. To help, we suggest investors reframe the recession debate and refocus on historical performance during previous Federal Reserve interest rate cycles.
By reframing away from recession and toward Federal Reserve interest rate regimes, we believe it may be possible to map out an informed path forward.

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Based on our recent client conversations with financial professionals, market sentiment is decidedly negative against a backdrop of higher interest rates, tightening liquidity, stubbornly high inflation, and ongoing turmoil among regional banks. This dynamic elevates the probability of a recession and/or an equity market downturn. In this Portfolio Construction Insight, we discuss the apparent paradox between market sentiment and investment positioning, and we offer potential strategies for dealing with this challenging investment environment.

The Paradox: Positioning Doesn’t Reflect Sentiment

On one hand, investors indicate a desire to prepare portfolios for recession and move toward more defensive positioning. On the other hand, however, portfolios still appear positioned for rising rates and inflation.

During 2022, the average financial professional in our client database reduced exposure to core bonds and increased short duration and cash positions to defend against rising interest rates. They also increased exposure to real assets stocks to combat higher inflation. Coupled with an increase in alternative positions partially funded from fixed income, these moves have resulted in higher-beta portfolios and increased cyclicality.

As a result, the prospects for downside in a potential risk-off event are increased. In addition, such positioning appears inconsistent with the widely held belief that the Fed may be nearing the end of the current tightening cycle.

The current Fed rate hike cycle may be nearing an end.

(Fig. 1) Federal Reserve Interest Rate Cycles*, 1992 to 2023

*A rate hike cycle is defined as a period of increasing rates with minimal monthly periods of pausing (minimal = 3 or fewer consecutive months); a rate pause cycle is defined as any time within a hiking or cutting cycle during which the Fed target rate is the same for 4 or more consecutive months (approximately 3 Federal Open Market Committee meetings); a rate cut cycle is is defined as a period of decreasing rates with minimal monthly periods of pausing (minimal = 3 or fewer consecutive months).
Source: T. Rowe Price analysis using data from FactSet Research Systems, Inc.

Refocus on Historical Fed Rate Regimes

Are we entering a recession? If so, will it be an earnings recession? A rolling recession? These are some of the most frequently asked questions we hear from clients, and they show that slowdown concerns are real. However, we believe there may be a better way to frame the recession question.

In our analysis, however, we broke down past Fed rate cycles into three sections: rate hikes, pauses after rate hikes, and rate cuts. It’s important to note that most investors have greater conviction in their interest rate cycle beliefs.

At present, we appear to be nearing an inflection point in the current rate cycle, with the Fed nearing its terminal rate and widely held expectations that a rate pause is on the horizon. This anticipated change could offer an opportunity for investors to increase exposure to asset classes that historically performed better during a Fed rate pause and/or a rate decrease.

In Figure 1, we looked at historical Fed interest rate cycles since 1992. We found that rate hike cycles tended to last about 14 months on average. Rate cut cycles, on the other hand, tended to be shorter—in the range of 7 months— on average. Please see Additional Disclosures following this narrative for more information. We note that the current hiking cycle is within the average range, but it remains below the maximum cycle length by almost a full year.

What Should Financial Professionals Consider Now?

By reframing the conversation away from recession and toward interest rate cycles it may be possible to map a path forward. As shown in our analysis, core bonds, for example, historically have outperformed shorter duration fixed income as the Fed cycle transitions from rate hikes to a rate pause. This move could also help diversify the “paradox” portfolio back to a more balanced approach. Long- term U.S. Treasuries and higher credit quality has also worked in both Fed rate pause after hikes and Fed cuts cycles.

Fed Rate Hike Cycles: Equities and fixed income performance varied widely.

Equities: Growth outpaced value, while large-caps beat small-caps.
Fixed income: Unsurprisingly, shorter duration and agency mortgage- backed securities (MBS) tended to perform well during such cycles.

Large-cap equities outpaced small-caps in prior rate pauses after hikes and rate cut cycles.

(Fig. 2) Average Equity Returns During Prior Fed Rate Cycles

Long-term U.S. government debt outpeformed other fixed income assets in prior rate cycles.

(Fig. 3) Average Fixed Income Returns During Prior Fed Rate Cycles

Past performance is not a reliable indicator of future performance. Category average performance is for illustrative purposes only and is not representative of any specific investment product or portfolio.
Sources: T. Rowe Price analysis using data from FactSet Research Systems, Inc.; Morningstar Direct; Bloomberg. Asset class performance is represented by the respective Morningstar Category Average for all listed asset classes except the Bloomberg U.S. Agency Int. TR USD Index. Please see Additional Disclosures following this narrative for more information.

Fed Rate Pause Cycles: Both equities and fixed income delivered positive results, with less dispersion.

Equities: Growth edged out value but the gap narrowed. Large-caps slightly outpaced small-caps, while international broadly underperformed.
Fixed Income: Transitioned from short-duration leadership to long duration. U.S. long government debt outperformed, followed by corporate, core-plus, and core bonds.

Fed Rate Cut Cycles: Equities were negative, and fixed income strengthened.

Equities: Large-caps outperformed small-caps and value beat growth on a relative basis.
Fixed Income: Long treasuries performed best, and government bonds, including agency MBS, outperformed all other asset classes within each duration bucket. High yield was the worst performing fixed income asset.

Prepare for What Lies Ahead

If you’re interested in exploring how to prepare your portfolios for a changing interest rate cycle, we can help. Supported by the multi-asset experience and global resources of T. Rowe Price, our integrated suite of Portfolio Construction Solutions is designed to address your portfolio construction needs and help position your practice for success.

Portfolio Construction Solutions from T. Rowe Price

If you’re looking for ways to help your portfolios navigate today’s persistent inflationary pressures, we can help. Supported by the multi-asset experience and global resources of T. Rowe Price, our integrated suite of Portfolio Construction Solutions is designed to address your portfolio construction needs and help position your practice for success.

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Additional Disclosures

Bloomberg: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Morningstar: © 2023 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

Important Information

Risks: All investments are subject to market risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Value and growth investing styles may fall out of favor, which may result in periods of underperformance. Diversification cannot assure a profit or protect against loss in a declining market.

Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only.

The views contained herein are those of authors as of June 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This material is provided for general and educational purposes only and not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. T. Rowe Price group of companies, including T. Rowe Price Associates, Inc., and/or its affiliates, receive revenue from T. Rowe Price investment products and services.

Portfolio construction services discussed are available only to financial professionals and not to the retail public.

T. Rowe Price Investment Services, Inc., Distributor. Art of Clean Up® and Asset Allocation Model Review are offered by T. Rowe Price Investment Services, Inc.

Model Construction is offered by T. Rowe Price Associates, Inc. T. Rowe Price Associates, Inc. and T. Rowe Price Investment Services, Inc. are affiliated companies.

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