Video Update: Two Potential Severe Recession Scenarios and What They Would Mean for Your Fortress Portfolio

This week, we’ll continue our series breaking down inflation and a looming recession in 2023.

Chief Analyst Adam Galas uses history as a guide to predict the worst-case for both these scenarios and the Federal Reserve’s role in it all.

At Fortress Portfolio, we always want you to be ready for the worst. But thanks to your membership – and unlike average investors – you have access to a well-rounded strategy that’s designed to protect your finances from even the most severe economic setbacks.

Adam breaks down how our portfolio performed over the last time we faced a severe recession and which picks are best-positioned to thrive through it all this time around.

Click the image below to watch the video or scroll down to read the transcript.

Happy SWAN (sleep well at night) investing,

Brad ThomasEditor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Today we're talking about what could cause a severe recession in 2023.

Two weeks ago, we talked about how the most likely outcome for the economy in 2023 would be a mild recession, possibly starting in July.

Last week, we talked about what could potentially turn that mild recession into an average recession. (The Fed continuing to hike interest rates to 5% and then keep rates there to battle sticky inflation.)

Well, this week we're talking about the two potential scenarios that could result in a severe recession and what that might look like for the stock market and the Fortress Portfolio.

Now, this first scenario is the most likely with a 20% probability according to the bond market.

It's what Societe Generale Group and UBS have been warning about for over a year.

Scenario one, is the stagflation hell scenario if the Fed starts cutting rates too early. This is what the Fed did three times in the 1970s and once in the early 1980s.

Perhaps you remember Paul Volcker hiking rates to a record 20% in 1980 to battle 15% inflation. What most people might not remember is that he actually cut rates 12% from March 1980 to June 1980.

Inflation then went from 0% on a month over month basis to 1% in a matter of six months.

Now, for context, that’s a 13% annualized rate.

So essentially the Fed went from 20% back down to 8% and then had to go straight back to 20% because inflation proved far stickier than expected.

This is why we had two severe recessions in the early eighties and employment peaked at 9%.

And if that happened again today, that would mean 8.1 million job losses, the same amount we had in the Great Recession.

Now, the good news is this stagflation scenario is a 20% probability, and it's not likely to happen in 2023 or 2024.

That's because the downturn that the Fed is causing now is likely to tamp down inflation.

But the concern is that it might go from 9% to just 3 - 4% rather than 2%. And then if the Fed cuts too aggressively like they did in the early 1980s, inflation could skyrocket back up… Specifically, to around 11% to 12% by around 2026 or 2027.

Now of course, if that happens, then the Fed would have to hike well into double digits. But at the moment, the bond market is suggesting an 88% probability that the Fed will hike to 5% in May and then cut interest rates twice by the end of the year… And cut six more times by September of 2024, down to 3%.

For context, the Fed's official plan for the Dot Plot is to raise rates to 5% and keep them there… And to wait until September of 2024 to cut rates.

So the point is, if we do get a severe recession from this stagflation scenario, it would still be several years away and our Fortress Portfolio companies would have plenty of time to adapt.

Of course, if the Fed does hike interest rates to double digits, the stock market is going to be a tad upset. At the very least…

This is a scenario could potentially cause a lost decade…

But we are well positioned in Fortress Portfolio to handle that. For example, we have very strong exposure to infrastructure and energy, both of which did very well this last decade.

For example, in the last lost decade after the tech crash, Pembina Pipeline (PBA) went up 182%, Keyera (KEYUF) went up 256%.

Magellan Midstream (MMP) had a 408% gain, while Enterprise Products (EPD) went up by 521% and TC Energy (TRP) by 697%.

Not bad for a lost decade in which the S&P was flat and the Nasdaq was cut in half.

But there is one thing that could cause a severe recession in 2023… The debt ceiling.

It's a topic so complex and important that next week we'll talk about why it exists and what options the government has to prevent and/or avoid financial catastrophe.

But right now, let's talk about what could be the outcome of the U.S. defaulting on its debt.

Moody's has updated its debt ceiling crisis model and thinks that if we have a short default of two months, unemployment could increase to well over 8% by the end of 2025 and GDP could fall 4% to 5%. This would basically be on par with the Great Recession.

That's about 7.5 million job losses. And they estimate that the stock market would fall by about 33% to 38% from here.

In other words, a 43% to 47% peak decline.

Now, this would be a cataclysmic outcome that could happen relatively quickly.

So let me walk you through the debt ceiling math at the moment.

The U.S. Treasury Department has $281 billion in its general Treasury account and deficit spending is running at about $4.85 billion per day.

Now, the Treasury was expecting to receive on Tax Day about $150 to $200 billion. This was expected to give the U.S. Treasury a lot more wiggle room.

But instead, it came in lower than expected, at $108 billion. The current estimate for default is about 53 days from now on June 18th.

Now, part of the reason for the shortfall is because California, Georgia and Alabama pushed back their Tax Days to October 16th due to some state disasters. And California generates 15% of the government's income.

Now, there is some good news.

On June 15th, estimated quarterly tax payments from small businesses and corporations are expected to bring in $85 billion.

I myself will be chipping in $32,000 to the U.S. Treasury, pushing back the default by approximately 1/30 of a second.

You're welcome, America.

Now that $85 billion is expected to give the Treasury another 17 more days.

That pushes us back 17 days to July 5th, before the potential cataclysmic financial crisis could begin according to S&P, Fitch, and Moody's.

Now, the good or interesting news is that there is some kind of accounting trick that the U.S. Treasury Department can use to give us even more time.

Goldman Sachs (GS) estimates that it could give us another month, pushing us into August.

Now, I don't know what that accounting trick is, but the U.S. Treasury does provide daily updates of how much cash it has.

And I have a spreadsheet tracking all of this.

So after June 30th, we'll be able to see how it affects that daily deficit spending.

And I'll be able to update our real time debt default countdown.

I will be providing updates in future articles and videos as we approach that default date.

And of course, next week we'll talk about what emergency measures the government has in place to potentially deal with this looming financial disaster.

Now, what about Fortress Portfolio?

How would Fortress Portfolio be affected by a debt default?

Well, essentially, Moody's thinks the default would cause another severe recession, a Great Depression level downturn.

So let's consider that from a dividend perspective, and why I'm not worried about the debt default.

Just two of our holdings, U.S. Bancorp (USB) and Manulife Financial (MFC), cut their dividends in the Great Recession.

Now, USB actually remained profitable every single quarter. So why did they cut their dividend?

Well, because remember, there were bank bailouts going on left and right, and the Fed was worried that if only weak banks took the bailouts, then the market might freak out and punish anyone who needed one.

So the Fed decided everyone had to take the bailout.

And because, of course, it looks very bad (politically speaking) for four banks that are taking bailouts to pay dividends… They forced dividend cuts on pretty much everyone.

That's not what happened in the pandemic and it's not what's likely to happen in another severe recession.

How do we know? Because the equity Tier 1 capital ratio for banks is now twice that of what it was in the Great Recession.

Now, Manulife Financial did cut for its own stupid reasons (it was exposed at the time to some subprime mortgages).

But today, this A-rated insurance company has a far more conservative bond portfolio.

There's not a single toxic bond on its books. And management is so confident (even with the most anticipated recession in history looming this year) that it hiked its dividend 11% for 2023.

Main Street Cap (MAIN), Toronto-Dominion (TD), and Allianz (ALIZY) are the remaining financials in Fortress and all three maintained their dividends in the Great Recession.

Main Street, remember, is the only BDC in history to never cut in a recession.

And Toronto-Dominion hasn't missed a dividend payment in 166 years. The only time its ever cut its dividend was in World War II at the request of the Canadian government.

Today, Canadian banks are safe income institutions, primarily owned by pension funds and retirees. The day the Canadian banks cut their dividends is the day the sun burns out, the living envy the dead, and money will be the least of our problems.

What about Allianz? Well, it hasn’t missed a dividend payments since 1890, including paying U.S. investors during World War I and World War II when we were at war with Germany.

They also kept paying during the Great Depression and the 1918 Spanish flu pandemic that killed 5% of humanity.

And remember, they're an insurance company that had lots of life policies to pay out at the time.

Everything we else we own in Fortress was raising its dividends during the Great Recession because they are all stable, well-run businesses with battle tested management and conservative corporate cultures.

They always hope for the best, but plan for the apocalypse.

For example, EPD just became the first A-rated midstream company in history.

And our next portfolio recommendation, which will replace Highwood Properties (HIW) happens to be a recession resistant dividend. (A quick side note, HIW also maintained its dividend in the Great Recession and was just 1 of 17 REITs that did not cut its dividend).

Our 3000 points safety and quality model, which we use to determine dividend safety, includes over 1000 metrics and is designed to catch 95% of dividend cuts before they happen. This is a model that includes quarterly updates on all fundamentals after every earnings season. It also includes the expert consensus of management guidance.

We track every analyst that covers a company on Wall Street, every rating agency and bond market providing real time fundamental risk updates… Any time news breaks.

In other words, our team at Wide Moat Research is protecting and monitoring all the data that goes into creating your Fortress Portfolio. We're data driven and always follow the fundamentals to their logical conclusion. We track the big macro metrics that predict recession and debt ceiling risks so that you are never surprised by what happens on Wall Street.

I personally watch 20 hours of Bloomberg per week to make sure I get the macro takes from the entire blue-chip consensus. And follow the six most accurate economist teams in the world.

My passion for the economy, corporate fundamentals, and dividend growth verges on the obsessive.

So you don’t have to tune into every Fed announcement and analysis each and every transcript. I do it so that you don’t have to. And I enjoy every moment of it!

This gives me an opportunity to take my ten years of experience as an analyst and condense it down into the things that matter: safe, generous, and exponentially growing dividends in a low volatility sleep well at night portfolio.

In this way, I can help you achieve your financial dreams and retire in safety and splendor, not just in the good times, but even when the wheels are falling off the economic bus.

Thank you for joining us for this week and I hope you join us for next week when we talk about the debt ceiling.

We will discuss what it is, why it exists, and most importantly, what the government can do to prevent that cataclysmic financial crisis predicted by S&P, Fitch and Moody's that may be 70 days away.

And of course, please send us your comments and questions, so I can respond to them in these videos and in our monthly issues.

But please remember, I can't provide individualized investment advice.

Until next week.

This is Adam Galas, wishing you safe investing and a healthy, happy, and relaxing week.