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Recession risk: Investors should ‘stay true' to their asset allocations, strategist says

Goldman Sachs Investment Strategy Group Head of Tactical Asset Allocation Brett Nelson joins Yahoo Finance Live to discuss market risks, the odds of a recession in the U.S., Goldman Sachs’s market outlook, and where to find opportunities in the market.

Video Transcript

- Well, investors, they are certainly looking to corporate earnings for signs of a slowdown in the economy as well as cues on how the largest companies are handling higher input costs. Meanwhile, the Federal Reserve's latest interest rate decision, that's looming in the background with traders expecting further rate hikes to slow the economy.

A me now to assess the risk of a US recession, we've got Brett Nelson, Goldman Sachs Investment Strategy Group's head of tactical asset allocation. Great to have you here with us this morning. Take us into your perspective, your insights into how you see-- of course, coming into this next decision from the Fed, how you see that playing out within the markets.

BRETT NELSON: Yeah, well, thank you for having me. So there's no question that investors are facing a lot of uncertainty this year. We have the path of the economy, inflation, as you said, what central banks around the world are going to do, and, of course, geopolitical risks. And for that reason, we titled our outlook this year "Caution-- Heavy Fog," because we acknowledge that, even as you said in the lead-in, that we're putting about even odds on a recession this year.

But paradoxically, given that backdrop, you would think that our advice to clients would be to bunker down and be very defensive. But in fact, we think that clients should stay invested. We do not recommend that they should be positioning themselves exclusively either for a hard landing or a soft landing. But we think that because not all recessionary paths lead to negative equity returns at the end of this year, that in fact, a moderate risk portfolio could actually do quite well this year with high single-digit gains. And therefore, we recommended that clients actually stay true to their strategic asset allocation this year despite the uncertainties.

BRIAN SOZZI: Brett, get even more tactical for us here. Just given the outlook that you are talking about, where can one go to generate alpha? What sectors, what strategies should they be putting in play?

BRETT NELSON: Yeah, so because we have this kind of uncertainty that's overhanging the outlook, we're not recommending at this point big deviations, as I said, from that strategic asset allocation. But we do have some tactical positions in the portfolio. So more broadly, we prefer duration over credit risk this year given that we do expect interest rates to come down in an environment of below-trend growth and the Fed probably closer to the end of their hiking cycle obviously than the beginning. That's a departure from last year where we actually favored credit over duration given an expectation of rising rates.

And so having one's bond allocation to its full extent is actually an interesting position today given that, one, if you do have a recession, it's a good hedge for that outcome, and secondly, in our base case, m the returns look attractive there. And then we also have a few tactical positions in Europe. We like the European energy sector. We're also overweight the European banking sector. And then here in the US, we have an overweight to the MLPs, or the Master Limited Partnerships, which are the pipeline companies that basically transport gas and oil around the United States.

- Interesting, stuff there, Brett. I'm going to take the opposite side of this, because you have a lot of ifs in the report, and you make it clear that there's still a lot of uncertainty. And we mentioned before the break that you're assigning about a 45% to 55% probability that there could be a recession. You say in your report if a recession is averted, financial market returns in 2023 will be less volatile. So there's a lot of questions out there. What is the biggest risk area if we do enter a recession? Where do you not want to be invested in case that is happening?

BRETT NELSON: Well, I think it really depends on a lot of different factors. I'd love to give you a clear-cut answer. But I think at the end of the day, the depth of the recession is a big factor, and when the recession ends is very important. So as we detail in the report, even if we were to have a recession this year, and even if that recession were to end by the end of this year, we actually think that would still be consistent with our base case forecasts of the S&P 500 delivering something close to double-digit returns.

Now, that may seem very counterintuitive. But when you look at the dynamics around recessions, what you see is that the earlier they start, the more time the equity market has to recover. Because at the end of the day, we know equities are forward-looking. They tend to bottom about six to nine months before earnings reach their low point. And the recovery from once they bottom to the end of a recession typically tends to be about 20% over a course of three months.

So even if you had a recession that ended in December this year, given that equity markets would be rallying into the last quarter of the year based on the historical analogs, that could still get you to positive returns. So the bad-case scenario is really that we avert a recession this year or we have a recession that's much deeper than we expect or that it lasts a lot longer than we expect.

But as I said, given the contours of what we're talking about, and as we talk about in the report, the US economy is very well balanced today. It doesn't have the cyclical excesses that typically precede past recessions. Consumer balance sheets are healthy, et cetera. And therefore, we think that if we did have a recession, it would likely be mild. And that's why we're leaning in that camp of positive returns even in the advent of a mild recession provided it ends by December of this year.

- We've continued to hear that consumer balance sheets are healthy, but given the fact that consumers also have been hearing the word "recession" perhaps every single day for the past year at this point, almost, is it possible that you could have a consumer behavior that actually starts to act like we are in a recession well before one is actually declared or the deepest kind of elements of a shallow or a mild recession are actually seen in the data? And what kind of broader implication might that have in the pull forward of the behavioral economics of it?

BRETT NELSON: Yeah, it's a really interesting question. We know markets are forward-looking. We know that people generally adapt to conditions. So arguably, the flip side of the argument you're making is that people are so fatigued with the idea of inflation now that investors, consumers, they've already made the requisite adjustments in their spending and other things because they've been dealing with this overhang of recession risk literally since the first two quarters of last year. Recall we had two quarters of negative GDP, and everybody started talking about recession.

And in fact, what's interesting is that if you look at the count of stories on Google or you were to look at just general story count around recessions-- we did this analysis, and there was actually more stories on recession last year than there was in 2020 when the US was actually in a recession. And similarly, if you look at the percentage of economists that are forecasting recession for this year, it's the highest on record.

So arguably, our view, at least, is that from a financial market standpoint, markets are forward-looking. They tend to look at what's happening around the turn. And part of the thing that's led to equity drawdowns in the past is the fact that people were surprised by a recession. This is arguably the most anticipated recession we've ever had. And therefore, we think that would dampen any downdraft just because the market and consumers, businesses have had a lot of time to acclimate to this idea that there might be an economic contraction and adjust their behavior accordingly.

BRIAN SOZZI: Brett, I certainly contributed to that. Last year, I think I wrote about recession for 30 straight days in one month. True story. Goldman Sachs Investment Strategy Group Head of Tactical Asset Allocation Brett Nelson, good to see you. We'll talk to you soon.

BRETT NELSON: Thank you.