Investor surveys, and now the US yield curve, indicate a high likelihood of a recession in the US. The question seems not whether there will be a recession, but when. Economist forecasts and earnings growth estimates, however, suggest a recession is not so certain. With growth already slowing more quickly than expected, markets are assuming central banks will not hike policy rates as much as was thought. But inflation may not fall enough to make that possible.
While many expect a contraction in the US, equity markets and economists still appear to view the future as fairly bright.
- Some models of the US Treasury yield curve do not show it inverted to the point that historically has signalled a recession.
- Consensus estimates by economists indicate growth will bottom at 1.1% in the first quarter of 2023 before rebounding to 1.6% by the end of next year.
- Equity analysts are still forecasting US earnings growth: consensus estimates point to 9% growth in 2023 (see Exhibit 1). In the event of a recession, earnings would likely fall.
Rate rise expectations and yields may rise further, and hence US equity valuations may still be at risk, but we believe valuations have now largely normalised. The main driver of equity returns from here will be earnings.
Recession – when, not if
Recession would raise two questions for investors:
- When should I change allocations?
- Which sectors or styles should I prefer?
It may only be early in 2023 that allocations should turn more defensive. We note that the average return of the S&P 500 during recessions has been just -3.0% since 1946. This modest number reflects markets anticipating recovery at the end of a recession in the same way as they anticipate the downturn.
Historically, defensive sectors outperform cyclicals during recessions, and growth beats value as interest rates and commodity prices drop. Stagflation is likely to hit fixed income harder than equity portfolios (more on the fixed income outlook below).
Will we see stagflation? While recession may well occur in 2023, inflation may have fallen already. It is forecast to have dropped to 4% a year from now and to fall further after that.
Recession risks from higher central bank rates appear to be lower in the eurozone than in the US given that eurozone core inflation at 3.7% is ‘only’ roughly half as high as it is in the US. Valuations of eurozone equities are more attractive relative to those in the US.
But there are other risks. Russia may cut off its gas exports. Moscow may view the financial costs of such a halt as manageable, but for the eurozone, this would almost certainly cause a deep recession.
A smaller risk comes from the effect of ECB rate increases on ‘peripheral’ bond markets, particularly Italy. However, the ECB’s anti-fragmentation tool should help keep Italian government bond yields from rising to above 4% – the estimated rate at which debt sustainability becomes a concern.
China – Trouble elsewhere
Chinese equities were making up ground relative to developed market equities until concerns over its property market slowed the rebound. Homebuyers refusing to make mortgage payments for unfinished properties have weighed on the financials sector. As for the pandemic, renewed outbreaks have led to Beijing imposing selected lockdowns, hitting consumer confidence and production.
We believe there is upside further out. Recoveries from previous lockdowns have been swift. An effective mRNA vaccine, which would allow for an early exit from the zero-Covid regime, may be close.
Importantly, valuations are attractive and we have confidence in the medium-term earnings outlook, particularly for the technology sector.
US bonds – Underappreciated risks
We think the Federal Reserve will struggle to weaken demand and engineer a soft landing. Bringing wage increases back in line with productivity gains and the inflation target may require a recession. Helpfully, the economy has been slowing. Inflation, however, is still spreading.
A focus in the markets on recession concerns is an indication that tightening financial conditions and high energy prices are already acting as a brake on the economy. The question now is how much more monetary tightening is needed to choke off inflation.
We believe the Fed should take policy rates into restrictive territory expeditiously, in other words, to 3.75-4.00% by the end of 2022. This is higher than market pricing for 3.25%. We think additional rate rises are possible, indeed probable, in 2023. We see a risk that inflation is more entrenched and structural than is widely thought. A modest slowdown might not be sufficient to vanquish it.
We assume real yields need to be driven higher than was the case at the end of the 2008 cycle, when policy rates hit 2.75% and core PCE inflation was barely 2.1% (versus 4.7% currently).
US Treasury buying amid signs of a slowdown and the simultaneous pullback in Fed rate rise expectations look unjustified to us. The idea that the Fed would stay its hand at the first whiff of slowdown or equity weakness seems misguided. If inflation is indeed structural, lowering it could mean policy rates have to stay high for longer than markets are currently pricing.
ECB skewed to over-delivering
We expect eurozone headline inflation to peak in September at around 9%, with risks remaining to the upside. Theimpact on growth from the Ukraine war is becoming visible. There is evidence that the uncertainty and weak consumer confidence are starting to weigh on business sentiment.
The ECB will likely have to revise its inflation projections higher in September. With price increases becoming more widespread, wage growth starting to pick up and signs of rising inflation expectations, the 125bp of rate rises signalled so far look more like the lower bound of ECB action.
However, a sudden and full shutdown of gas imports from Russia will likely push the eurozone into a severe recession. In such a scenario, the fiscal response will likely be large for sectors subject to energy rationing and lower-income households, though the impact will be asymmetric across economies.
Given current inflation, a strong labour market, and the ECB’s focus on delivering price stability, we believe the risks are skewed to the ECB over-delivering rate rises versus current market expectations. Over the medium term, we expect inflation to slow consumption, while a terms-of-trade shock would leave employers little room to raise wages.