Investment Strategy Brief:
What Path Will the Economy Take?

Below is a transcript of this week’s video.

(Chart 1 – Title slide) Hi, this is Mike Reynolds with Investment Strategy at Glenmede
From everyone at Glenmede, we want to wish you a happy, healthy and prosperous 2023.
(Chart 2 – Framework) While we’re kicking off a new year, not much has changed on the economic front. The Fed is still
tightening, the risk of recession remains elevated and stocks are still in a bear market. As it stands now, investors should remain
defensively positioned in anticipation of further downside to the ongoing bear market. With that said, they should also be
careful not to become too complacent with that positioning. In practice, investors should be constantly surveying the
macroeconomic and market landscape for signs of an inflection point. The slide shown here is an exercise in the hypothetical
scenarios that could prompt such a change in strategy. There are likely three main paths the economy and markets could
take that could prompt a change in stance for investors. The first path assumes the U.S. avoids a recession, which likely means
the Fed was able to wrestle inflation under control in a timely fashion without too much collateral damage in the broader
economy to cause a downturn. The second is one where the Fed is not so successful at threading the needle and the
economy does enter recession. And the third, which could very well occur concurrently with the second scenario, is a decline
to fair valuation levels on equities. Let’s walk through these scenarios one by one.
(Chart 3 – Recession Watch) The first scenario, where the Fed achieves a soft landing and avoids recession, it’s so far so good.
The chart on the left shows quarterly real GDP growth, which ticked up positive in Q3 and is expected to remain so in Q4.
While there is an informal shorthand definition that two straight quarters of negative growth typically means recession, the
official definition is a bit more involved than that. The National Bureau of Economic Research makes the official call on when
the economy enters recession, though their academic approach tends to lead to significant lag times in calling such crucial
turning points. Instead, investors should keep an eye on some of the variables the NBER tracks, such as employment, industrial
production and retail sales. Of the three scenarios, this is probably the least likely to occur. But if it does, it likely means the Fed
was able to bring inflation under control relatively quickly, keeping the U.S. economy in its late stages for the time being.
(Chart 4 – Fed Funds vs. Neutral) The biggest reason why avoiding a recession is unlikely at this point, is that the Fed has taken
rates into tight territory, as shown by the blue line here rising above the green. Monetary policy notoriously flows through to
the economy with long and variable lags, so the impact is unlikely to be felt immediately. What’s more is that the Fed plans
to continue raising rates into 2023, which should start to have negative ramifications for the real economy and lead to
recession.
(Chart 5 – Capex & Employment) Some of those variables that might give a clue as to when a recession is unfolding have
remained healthy for the time being, but investors should be watching things like capital expenditures as shown on the left
and the unemployment rate shown on the right. Rather than waiting for the NBER to make their recession call, these variables
could start to give hints of trouble on the horizon for the economy ahead of time.
(Chart 6 – Earnings) If the economy does start to take a turn for the worse, such an event should impact corporate earnings
and perhaps trigger further declines in equity prices. The table on the left gives an idea of the history of earnings declines
during recessions, which comes out to a 15% hit on average. As shown in the chart on the right, which is how estimates for
2023 earnings for the S&P 500 has evolved over time, a 15% decline would lead to about $190 earnings per share. That’s
materially lower than the $230 mark that analysts are currently pricing in. This is another factor that could prompt further
declines in stocks, as earnings weakness becomes a reality. This recession scenario is the base case at this point in time. Once
the recession begins, investors should be looking to key leading indicators for green shoots that could herald a durable
recovery in the economy and the start of a new economic cycle.
(Chart 7 – LC Bacon) The third scenario is a decline to key valuation levels, where stocks begin to trade at such a discount
that it no longer warrants an underweight position. The green line in the chart here is where U.S. large cap valuations sit within
the gray percentile ranges around the fair value line in blue. During periods of economic stress, it’s common to see valuations
dip below fair levels, but that’s something we have yet to see this time around.
(Chart 8 – Cycle Valuations) In general, equity valuations tend to be sensitive to the stages of the business cycle, where they
have historically traded at deep discounts in recessions, recovered coming out of recessions and peaked around late cycle.
Glenmede’s Global Expected Returns Model suggests that the 3250 level on the S&P 500 marks fair value. Below that level,
investors seeking buying opportunities should look to those turning points in the economic cycle and perhaps contrarian
sentiment signals to appropriately time adding to risk.
(Chart 9 – Summary) So to summarize, given the ongoing economic uncertainty, investors should maintain an underweight to
risk assets, but should also be surveying the scene for the trigger points that could warrant adding back to risk. The first trigger,
though unlikely at this point, is if the Fed achieves that soft landing and avoids recession. The more likely outcome is a recession
in the U.S. that also hits corporate profits. Such a scenario suggests further downside for equities in the near-term. And the third
scenario, which could happen concurrently with a recession, is a decline to more fair valuation levels. Given this outlook,
investors should stay underweight until they begin to observe mid-recession green shoots of recovery and/or more attractive
valuations before getting more constructive on risk in their portfolios.
Thanks for listening! And please don’t hesitate to reach out with any questions.

This material is intended to review matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. When provided to a client, advice is based on the client’s unique circumstances and may differ substantially from any general recommendations, suggestions or other considerations included in this material. Any opinions, recommendations, expectations or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Outcomes (including performance) may differ materially from any expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss any matter discussed herein with their Glenmede representative.