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The Fed Is Officially Ignoring a Recession Problem
Last month, Fed Chair Jerome Powell provided an unappetizing view on inflation.
“The inflation outlook has deteriorated significantly this year… the median FOMC projection for year-end 2022 [inflation] jumped from 2.6 percent to 4.3 percent.”
Since then, the Federal Reserve has indicated it could raise rates up to eight times in 2022.
But the same inflation-fighting tools can make the economy lose its lunch. Just ask anyone who’s ever tried buying a house when mortgage rates climb into the double-digits. The same way a fever can inadvertently kill healthy cells, rising rates can choke the same economy they hope to cure.
History provides a stark warning. Goldman Sachs Chief Economist Jan Hatzius notes that 11 out of 14 tightening cycles since World War II have preceded a recession within the following two years. His team now predicts a 1-in-3 chance of a recession by 2024.
The FOMC however, is still ignoring these alarm bells — much like how I ignore my kitchen’s smoke detector every time I cook. Mr. Powell has repeatedly assured markets that the economy can achieve a “soft landing” while unwinding its $9 trillion balance sheet. The FOMC’s official unemployment projections for 2023 remain at 3.5%, a rosy forecast shared by few on Wall Street.
As the Fed continues to fall behind the curve, investors are starting to ask themselves, “what next?”
Regardless of what happens, one particular group of stocks stands to gain:
Deep value stocks.
The Deep Value Winners of a Recession
Regular Moonshot readers have already seen a parade of deep-value winners. In March, my No. 2 pick for 2022, Volt Information Science (NYSEAMERICAN:VOLT) jumped 100% on a takeover offer. Even the Enservco (NYSEAMERICAN:ENSV) recommendation — which I unflatteringly described as “a struggling oil and gas services company that has failed to generate profits since 2014” — managed to advance over 500%.
As interest rates and recession fears rise, these kinds of companies with plenty of assets tend to thrive.
Yet deep value stocks are also a minefield of problems.
Gold miners (a logical winner of recessions) can in fact underperform during times of stress. Barrick Gold (NYSE:GOLD) saw shares drop 60% during the 2008 financial crisis; many smaller miners did even worse as credit dried up.
Even now, dirt-cheap companies like Rite Aid (NYSE:RAD) struggle to regain their footing. On April 7, RAD shares slid 26% after Deutsche Bank warned the company could soon go bankrupt.
The Downside to Downsides
Many deep-value stocks are cheap for good reasons. The majority of gold miners fail to earn their cost of capital over time. From an economic standpoint, it’s like watching a slow-burning candle disappear hoping it will magically grow back.
Meanwhile, companies like Rite Aid are swimming up to their eyeballs in debt — a warning I initially issued back in January, long before Deutsche Bank cut RAD’s target price to $1. Rising rates make refinancing more expensive, and highly indebted firms often find themselves pleading for bankruptcy before long.
Wall Street often calls these duds “value traps.”
I call them bad investments.
The Best Defense…
So, the question remains: what are “good” value investments?
As longtime Moonshot readers will know, good investments follow a simple principle: The best defense is a strong offense.
Consider the alternative. Investors who buy 30-year bonds today will trail inflation by 550 basis points. And even high-dividend stocks are often melting ice cubes in an overheated kitchen (Don’t worry about the smoke alarm, I assure you that’s normal).
Instead, outrunning recessions involves picking deep-value firms with plenty of growth potential.
Team Inc (TISI)
At first glance, this Texas-based staffing firm looks like a smaller version of Volt Information Sciences — cheap, low-margin and with plenty of potential upside. Shares are already up 54% since January.
But there’s a reason why Team Inc (NYSE:TISI) is now one of Moonshot’s top countercyclical plays:
Its focus on the American oil, gas and manufacturing industries.
Team Inc is a critical player in pipeline and energy storage inspection. Any firm building a new oil well needs to hire Team Inc or one of its competitors to meet environmental standards. And even areas not governed by the EPA — from water pipelines to manufacturers — can still require consistent monitoring.
That means America’s newfound focus on national security is driving unprecedented demand for Team Inc’s services.
The Countercyclical Value Stock
On the energy side, Team Inc is seeing a renaissance in its refining and pipeline business. The U.S. Baker Hughes rig count now sits at almost 700, its highest level since the pandemic. And the U.S. Energy Information Administration (EIA) now forecasts 2024 production to reach almost 13 million barrels per day — 30% higher than in 2020.
Tightening emissions-related standards are also driving demand. The U.S. Department of Transportation is expected to expand federal pipeline safety standards to all onshore pipelines this year. 425,000 miles of additional lines will soon require safety inspection and reporting.
Meanwhile, Team’s other work in manufacturing, aerospace and chemicals is seeing a similar boom as American businesses reinvest in domestic capacity.
“We anticipate a strong outlook for our products and services over the next several years,” Team Inc CEO Amerino Gatti said in the most recent earnings call. “Over the last two years, we have seen a significant number of projects get pushed or delayed…. This is a trend that is not sustainable and is creating a backlog of capital projects and unscheduled shutdowns due to equipment failures.”
As American companies continue ramping up capital investment, Team Inc’s bottom line will grow significantly.
The Risks of TISI
An investment in Team isn’t entirely without risk.
The company has been unprofitable since 2015 — the year American energy markets cratered. And TISI’s fiscal deficit has resulted in a $405 million-sized hole of long-term debt that could cost $50 million per year in interest payments alone.
Management’s acquisition strategy has also been questionable at best. Team Inc has written off $300 million of goodwill since 2020, a vast sum for a company that generates just $220 million in gross annual profits.
Finally, the company’s history of losses makes valuation difficult. A return to $70 million EBITDA — a reasonable guess for 2023 — would price the firm at around $3.50 per share, a 100% upside from current levels (assuming a 9x EV/EBITDA multiple with an appropriate discount rate). But achieving only $50 million EBITDA would make TISI worth zero by the same metric.
Still, these short-term issues are common with deep-value stocks — it’s virtually impossible to find a blemish-free one. And given Team Inc’s potential for structural growth, the deep value staffing play will be a better bet than most.
Why Do Rising Rates Cause Recessions?
In 1955, the American economy was booming. The Korean War had ended two years before, and an entire generation of Depression-era kids was now starting families and joining the workforce. For millions of Americans, it was a golden age of prosperity.
But economic success also came with downsides. As demand for private debt and equity financing grew, interest rates tripled to 3.8% by 1957. Within months, America would find itself in its deepest recession since World War II.
Though the Recession of 1958 is now a mere footnote in economic history, one truth has remained.
Rising rates are often clear signals of impending downturns.
Rising Rates Often Predicts Recessions
Since the 1950s, recessions have followed rate rises eleven out of fourteen times, according to Goldman Sachs Chief Economist Jan Hatzius.
High interest rates act as a “brake” on economic activity. As mortgage, credit card and bank loan rates go up, individuals and companies alike borrow and spend less. A homebuyer should be less willing to buy a house if mortgage rates rise to 10% than if they drop to 2%.
From an inflationary standpoint, rising rates are often a good thing. By making it more expensive for banks to lend to each other (and to consumers), the Federal Reserve can limit the amount of money flowing through the economy.
And less money in the financial system generally means less ability for prices to rise.
But the downsides are also evident. If you remove an entire cohort of homebuyers from the market, the chilling effect can spillover to homebuilders, timber producers, real estate agents and so on.
In the financial world, the stakes are even higher. Rising rates can cause a “doom loop,” an ominous term familiar to any European-based banker.
As bank lending contracts, the local economy can shrink as businesses struggle to borrow enough cash to keep operating. Deteriorating credit quality can cause banks to cut lending even further, creating a runaway feedback loop.
Can America Avoid a Recession?
America has managed to avoid such fates before. In 1965, 1984 and 1994, the Fed raised rates without causing a downturn. And rising rates in 2019 might have ended well had the Covid-19 pandemic not struck.
But engineering a “soft landing” is a bit like threading a needle while riding a bull.
“No one expects that bringing about a soft landing will be straightforward in the current context,” noted Jerome Powell in a March speech to the National Association for Business Economics. “Monetary policy is often said to be a blunt instrument, not capable of surgical precision.”
That’s because inflationary-fighting rate increases need to be strong enough to change inflation expectations. Too weak, and markets can continue raising prices. But come on too strong and the Fed can trigger a dreaded “doom loop.”
The same analysts at Goldman Sachs are now predicting a 35% probability of recession by 2024 — far lower than the 78% of periods where slowdowns have followed rate rises, but much higher than in average years.
So although America still has a 65% chance of avoiding economic stagnation, that shouldn’t lull investors into complacency quite yet. Instead, they should be seeking out investments that can both survive and thrive if a recession does indeed come.
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On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.