- Federated Hermes’ Steve Chiavarone isn’t outright bearish, but he’s cautious about the economy.
- The strategist and portfolio manager predicts a coming recession in 2023 or 2024.
- Here’s how investors should position their portfolios and allocate money to stocks and bonds.
Last October, Steve Chiavarone waved the green flag for stocks – with a caveat.
The $631 billion equity strategist and head of multi-asset solutions Federated Hermes had a 2021 year-end price target of 4,800 for the S&P 500, and predicted the index would rise another 10% to 5 300 by the end of 2022 – although he told Insider that inflation was a serious threat.
The 500-component index ended 2021 within 1% of Chiavarone’s price target, even as prices rose significantly. Investors largely discounted inflation risk and continued to send equities higher.
But less than six months later, that 2022 year-end price target seems unlikely. The S&P 500 has fallen 12.7% this year to around 4,160 as investor risk sentiment evaporates.
One of the main reasons for this is that inflation is now impossible to ignore, even for government officials who long minimized his seriousness. There are growing fears that price spikes will force the
Federal Reserve
raise interest rates to a level that slows growth and causes a
recession
. Some experts believe that rates have already risen enough, but Chiavarone is not buying it.
“It’s very popular to mean ‘peak inflation, peak Fed aggressiveness,'” Chiavarone told Insider in a recent interview. “Well, I’m not so sure. And here’s what I mean by that: Do I think inflation is necessarily going to pick up significantly from here? Not necessarily, but I don’t think this story is over either.”
Chiavarone later added, “The market, again, erred into some complacency around the Fed.”
6 signs of recession to watch out for
While Chiavarone certainly isn’t complacent about the threat that inflation and rising interest rates could continue to pose, he said his view of the economy isn’t “outright bearish yet” either. .
“Even with the rate hikes coming and even with the economic slowdown that’s going to result, it’s just going to take a while,” Chiavarone said. “The economy had so much momentum, and the indicators were so strong, and consumers and businesses were so well capitalized that you’re going to get a little harder landing, but it’s going to take time.”
The strategist continued: “Our view is that you’re unlikely to be in a recession in 2022, but if you get into late 2023 or even early 2024, I think those odds increase significantly.”
A recession in 2023 or 2024 is Chiavarone’s base case because he thinks the alternative – a so-called “soft landing” where the US central bank slows inflation without hurting the economy – is a long wait. . Even Fed Chairman Jerome Powell admitted it would be “difficult”.
“The opportunity for the Fed to stage a soft landing — historically that’s not the most likely outcome,” Chiavarone said. “And I think given how late they started and how far they’ve let things go and how much they’re going to walk this year, I think a hard landing is a real possibility here.”
There are six indicators that Chiavarone says have historically foreshadowed a recession: a jump in unemployment claims, rising inflation, a decline in housing starts, an inversion of the yield curve of 10-year U.S. Treasuries versus federal funds, a spike in high yield bond spreadsand a drop in the ISM manufacturing report.
Specifically, Chiavarone is watching unemployment benefit claims rise 64,000 from their short-term low – they are currently 34,000 off their low of 166,000 set in March. Inflation – as measured by core personal consumption expenditure (BCE) – more than 1.6 percentage points above normal is also a big problem. Unfortunately, it’s a brand he has already well past.
Meanwhile, Chiavarone is monitoring housing starts down 690,000 – so far they’re just down 53,000. It also monitors the 10-year federal funds yield curve; it currently has a positive slope of about 2 percentage points, but if it reverses by 3.85 percentage points, Chiavarone says we are in trouble.
Regarding the last two indicators, Chiavarone says investors should worry if high yield bond spreads hit 7 percentage points – they are still a few percentage points away – and if the ISM manufacturing report were to fall to 47.8 from its current position. 56.1.
These signs are “not a magic formula”, but rather are meant to be useful economic barometers when the level of deterioration and the period in which it occurred are taken into account, the strategist said. Five of the six indicators appear to be out of dangerous territory, for now.
“It’s really just the inflation fingerprints that indicate a recession at this level,” Chiavarone said.
How to structure a portfolio
In addition to leading multi-asset solutions at Federated Hermes, Chiavarone is also a portfolio manager who helps manage his company’s global allocation fund (SBFIX). The product has outperformed the S&P 500 so far this year and has beat 70% or more of competing funds over the past five and ten years, according to Morningstar.
Currently, Chiavarone said it is about 3 percentage points overweight in equities and cash and is structuring its portfolio as follows: 63% shares, 31% fixed incomeand 6% in cash.
The portfolio manager said he is currently focusing on two main groups of stocks: cyclic and defensives that pay dividends.
Economically sensitive stocks in sectors like energy, materials, industrialand finance are a key part of the Chiavarone portfolio. But the strategist said stocks in those sectors were a “limited time supply” with the economy set to slow, and he is now inclined to sell cyclicals on rallies.
Conversely, Chiavarone said he would buy dips in dividend-paying stocks in defensive sectors like basic consumption, utilitiesand Health care to prepare for a possible recession. The portfolio manager highlighted these two former sectors in February in what he predicted would be the “revenge of boring stocks”. His affinity for consumer staples is a departure from his disdain for the group in October.
Apart from specific sectors, Chiavarone considers large companies more favorably than small caps as interest rates and recession risks rise. He added that it is “difficult to be overweight other than the WE at this point” as the Russian-Ukrainian war weighs on the European economy, while China’s controversial “COVID-zero” policy cripples that country’s economy.
In terms of bonds, there may not be a rally for the beleaguered asset class anytime soon as “downside pressure” remains for the group, Chiavarone said. The Fed’s decision to reduce
liquidity
by selling bonds drove down prices, which drove up yields.
However, investors should watch closely for a chance to strike, as economic weakness leads to a flight to safety in the form of long-duration bonds. When the 10-year yield rises between 3% and 3.25%, the strategist said it could be a sign to dive into the downcast band.
“I think there’s an opportunity – not yet – but I think there’s an opportunity over the next six to 12 months where you’re really going to want to go long in fixed income and buy some longer-term bonds,” Chiavarone said.
Chiavarone continued, “As the rate hikes start to hit the economic data and the economic data softens and a hard landing looms, you’re going to want to have longer duration fixed income securities in your portfolio. , which no one wants to touch this year.”
On Monday, just days after Chiavarone’s call, the 10-year yield topped 3% for the first time since 2019. Investors targeting longer-dated bonds should consider pairing them with their shorter-dated counterparts as well as to cash, the portfolio manager said. said.
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