The US stock markets have two major headwinds in the months ahead: the first is a looming recession in the second half of the year as the US Federal Reserve’s inflation-busting rate rises take effect; the second is that the US market, in aggregate, still looks expensive relative to other markets and to its own history. Nevertheless, a careful investment approach can address both problems.

Recession now appears likely at some point in 2023. The Federal Reserve has remained firm on restoring price stability and has kept to its rate rising strategy. Supply and demand need to be in balance, or inflation will become entrenched. Higher interest rates are necessary to squeeze excess demand out of the system, even with some inflationary factors – such as high commodity prices – starting to ease.

In an ideal world, the Federal Reserve could raise rates just enough to bring inflation under control, but without causing a recession. However, in the past that feat has proved near impossible to achieve. It is extremely difficult to fine-tune an economic ‘soft landing’. Also, inflation has proved ‘stickier’ than many expected and may require more concerted action to get it back under control.

A recession seemed remote at the start of this year, as the employment market and wage growth continued to be strong, but has started to look plausible in recent weeks, as employment growth shows signs of weakness. The banking sector turmoil also makes it more likely. Banks are already reining in lending and tightening credit conditions. This has an impact on the broader economy and business and consumer confidence.

It may also be a symptom that higher interest rates are starting to be felt in the system. When rates rise, it can expose all sorts of unpleasant problems lurking in the system. These events are an important milestone to recession. In our view, not only is a recession necessary, but we are close to the conditions for that recession to take place. When it arrives, it is likely to be relatively shallow, lasting three quarters in length and taking around 2% off the economy.

Investing in a recession

A more complex question is how to navigate this recession as investors. The US stock market in aggregate does not look particularly appealing. The S&P 500 is trading on a forward price to earnings ratio of around 18x1, high relative to its history and to previous, similar periods in markets.

However, dig deeper and it is clear that these high valuations are driven by a handful of high growth companies. They became very expensive during the period of low interest rates and even more so during the pandemic. While that corrected somewhat in 2022, many of these stocks have rallied again in 2023, leaving them looking expensive once again.

In contrast, the US market holds plenty of good companies that are inexpensive, where investors pay a fair price for strong cash flows that are returned to them via dividends and buybacks. At a time of ‘free money’, valuations haven’t mattered, but we believe investors are likely to pay closer attention to valuation in a climate of higher interest rates. We are always attentive to valuation and the price investors are paying for the earnings companies are generating, but this is particularly important today.

Equally, we are looking for companies that can be resilient at times of recession. These might be stocks such as the Chicago Mercantile Exchange, which tends to do well during periods of market volatility. Agricultural sciences company FMC Corporation and defence company L3 Harris are holdings that should be resilient in a recession.

We have also used the recent market turmoil to add companies to the portfolio that looked unfairly sold off. Life insurer MetLife, for example, had been hit hard because of its weightings in commercial real estate, but the holdings were modest and high quality. We also added to a number of high-quality banks, such as JP Morgan, which looked cheap.

If there is a deep recession, markets will inevitably suffer, but that is not our central case. Ultimately, we only need 35-40 companies. For The North American Income Trust, we can find plenty of companies that can continue to thrive whatever the economic weather and look attractively valued.

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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