February 16, 2025

Economic stock market graph

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Reversing gains from earlier in Q3, the market rout in September brought US and global equity indexes back into bear market territory. Uncertainty, volatility, and the risk of recession are heightened, but investors should remember that innovations and opportunities will always emerge from periods of volatility.

Recessions are often the shortest part of the business cycle, but decisions made during times like these can shape investment outcomes for years to come. We believe that investors can use the current environment to reposition portfolios and use this opportunity to harvest losses for tax purposes.

Key Takeaways

  • We expect a gradual decline in the US economy that will be less severe than previous recessions.
  • Defensive and quality-focused positions remain relevant due to low income cyclicality.
  • The benefits of diversification are most noticeable in times of market turmoil, and they highlight the value of an investment plan.

We Expect a Gradual Slowdown in the US Economy

Every recession is challenging, but every recession is different. Recent memories may affect how investors react to this economic slowdown. However, the COVID recession and the Global Financial Crisis are notable recent examples of periods of extremely slow economic growth.

Both examples include shock factors with multiple negative feedback loops, making them poor comparisons for the current period, where we expect US economic growth to slow down and the scale of this contraction is smaller.

But fears persist amid questions about how further economic expectations and the market environment could deteriorate. In the US, banks remain well capitalized, consumer and corporate balance sheets remain healthy, and the labor market is tight.1

While a continued contraction is likely to weigh on each of these elements, the current strength in these areas suggests the potential for a shallow US recession.

However, due to the strength of the US dollar, markets currently expect US economic growth to outperform that of major international economies. The strength of the dollar improves US purchasing power on a global scale, but it weighs on US exports. In a prolonged global economic slowdown, reduced global demand for US products could weigh on US economic activity.

For a more detailed view of our economic outlook, please see our House Views.

Overcoming Investor Psychology in Times of Volatility

Economic uncertainty and increased market volatility have many investors in wait-and-see mode. Anecdotal evidence from our discussions with clients suggests that there is enough money on the sidelines waiting to be deployed, which gives cause for optimism while the uncertainties are fleeting.

Investor sentiment can be volatile, improving as uncertainty decreases. The rebound in the first two days of October shows how a small reduction in risk-off sentiment can have a big impact on risk assets.

The market recovery is likely to begin before the economy emerges from recession, possibly even before the full economic slowdown is reported in GDP growth numbers.

It’s important to remember that markets often overshoot in two directions: overzealous and overcautious. As Warren Buffett once said, “Be fearful when others are greedy, and greedy when others are fearful.”2

Position for Recession

Using a simple dividend discount model as a guide, all three key factors drive the price of a security – dividends, the expected growth of dividends, and long-term interest rates – affected by the current environment.

dividend discount model

The Fed’s rapidly increasing interest rates weigh on value through the discount rate. In our view, uncertainty is likely to continue until there is clarity on when the Fed will end their tightening.

Markets are now pricing in another 125 basis points (bps) of increases in Q4 2022 and 25 bps for Q1 2023.3 Some indicators point to US inflation picking up, but monthly numbers remain stubbornly high.

The trajectory of US headline inflation is likely to have a significant impact on market sentiment due to the Fed’s response. If US inflation normalizes quickly, markets may reduce rate hike expectations. The opposite is also true.

Earnings are likely to show weakness as economic growth slows. During Q3, earnings estimates for the S&P 500 were revised down by -6.6%, a larger downward revision than the average of -2.3% over the past five years.4

If the US experiences an income recession, some companies may be forced to cut their dividends or limit their dividend growth. The scale of these responses will determine the impact of intrinsic value.

Income cyclicality varies across sectors and industries. While economic growth is expected to slow, market segments with stronger earnings may be rewarded. Currently, we prefer defensive and focused on quality equities. The strength of free cash flow remains important.

We also favor US equity exposure over international developed or emerging market exposure. The strong dollar coupled with the energy crisis has intensified the impact of the dollar’s strength on the world economy.

The US economy is in a stronger relative position, but many US companies are exposed to international markets. The strong dollar weighed on the translation of foreign sales and earnings, and slower economic growth outside the US could hamper corporate earnings reports.

For more details on this impact, please see our Sector Outlook.

Positioning to Capture Long-Term Trends

Until now in 2022, the balance between interest rate sensitivity and economic growth sensitivity favors companies with high dividends. However, as the recession continues, the markets tend to start focusing on areas of stability and those that can grow despite the economy.

We expect investors to balance their exposures between companies that are defensively positioned, capable of growth despite economic weakness, and of higher quality with sustainable dividends and stable cash flow.

In our view, the main areas with long-term tailwinds materializing include renewable energy, the commodity energy transition, cybersecurity, and automation and robotics.

  • The European energy crisis remains one of the key risks to the market. Clean energy solutions will not solve the crisis, but they can be part of a longer term solution to improving energy independence. CleanTech offers innovation, and renewable power distribution provides utility exposure. Investors can combine these exposures based on the level of volatility they are comfortable with.
  • Lithium and battery technology are critical to the renewable energy transition. And as green energy technology scales and battery storage options improve, nuclear power can provide a clean and reliable energy source to help bridge the gap. In line to benefit from the increased use of nuclear power are uranium producers.
  • The ongoing digitalization of the global economy increases cybersecurity risks, raising the importance of companies implementing strict cybersecurity protocols. These protocols can create recurring revenue opportunities for companies that provide cybersecurity protection.
  • The tight labor market and rising wages are creating incentives for companies to automate their operations, including through the increased use of robots. We expect the robotics market to grow as robot costs decrease and deglobalization increases the need for efficient production and manufacturing.

Conclusion: Volatility Increases the Value of an Investment Plan

Volatility can drive large market movements in both directions, meaning that the best days in the market often occur during turbulent times. However, timing the market is extremely challenging even for the most experienced, and successful, investors.

When volatility hits, having an investment plan that keeps investors focused on their long-term investment goals can be critical, as market opportunities are often greatest at peak pessimism.

Bear markets create reset periods, where investors take advantage of depressed valuations to reposition portfolios as well as tax loss harvesting. While the current environment is scary, investors can use this opportunity to find bargains.

Excavating higher growth opportunities while maintaining a defensive posture helps make short-term volatility more tolerable while taking a long-term view.


Footnotes

1. Federal Reserve Economic Data and US Bureau of Labor Statistics data as of 29 September 20222. Warren Buffet3. Bloomberg data as of 29 September 20224. FactSet, Biggest Cuts in EPS Estimates for S&P 500 Companies for Q3 2022 in More Than Two Years, 30 September 2022

This material represents an assessment of the market environment at a specific point in time and is not intended to be a prediction of future events, or a guarantee of future results. This information is not intended to be individual or personal investment or tax advice and should not be used for trading purposes. Please consult a financial advisor or tax professional for more information about your investment and/or tax situation.

Global X Management Company LLC serves as advisor to the Global X Funds.


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Editor’s note: The summary bullets for this article were selected by the editors of Seeking Alpha.

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