When GDP numbers were released for the second quarter, they confirmed what we have known for some time. Economic growth is slowing.
Much of the focus has been on the semantics of whether we are in a recession or not, but that’s not our primary focus. Regardless of the label, it’s clear growth is decelerating, though it is against a backdrop of jobs numbers that remain resilient.
Most recently, consumer and corporate spending, which have to date been viewed as economic strengths, have slowed too. Real incomes are also falling as pandemic stimulus wears. These are significant shifts.
We believe we have arrived at a pivot point. Markets rapidly moved from wondering if and how the US Federal Reserve will respond to rein inflation in to questioning whether the economy can handle the Fed’s response.
Our base case is that we are entering what can be deemed an average recession, as measured against previous recessionary periods. An “average” recession would imply a shallow drop—a decrease of approximately 2–3% in real GDP—and a duration of about 12 months.
That’s a base case, and there is much that can vary from here.
Our clients, according to a recent survey we conducted, are anticipating a mild recession. While 89% of respondents to our survey believe that the US will enter a recession, 68% expect it to be mild, while 21% anticipate an average recession. No respondents indicated they felt it would be severe.
We think a softer landing for markets and the economy can be achieved if global supply chains recover, if commodity prices moderate (especially if the war in Ukraine de-escalates), and if wage growth moderates and labour force participation rises. On the other hand, if high inflation remains entrenched – and especially if wage prices begin to spiral – central banks will likely push markets to a harder landing through demand moderation (in the form of higher rates).
Volatility is likely to remain elevated in the months ahead as markets discern whether we’re in for a hard or soft landing. In general, our portfolio managers are focused on positioning defensively as well as the capturing opportunities likely created in the dislocations and more recent pullbacks in many asset classes and there are a number of signposts we are watching to determine the path ahead.
We anticipate that high commodity prices, tight labour markets, high housing costs, and shortages of goods and materials across industrial sectors will keep inflation elevated in the months ahead. Yet, it appears that inflation may have already peaked at very high levels.
July’s Consumer Price Index print is being interpreted as favourable by markets, though we think it’s notable that the breadth of inflation is actually still rising.
The Fed’s moves, which are part of the fastest global central bank pivot ever, appear to be having the intended effect, though we think it is too soon for the Fed to declare victory.
Inflation will likely drop as the Fed’s aggressive efforts to dampen demand take hold and supply constraints slowly ease. However, the peaking process will likely be longer and more arduous than anticipated as the underlying drivers of inflation have transitioned from acute price pressures in a few areas, such as used cars or airfares, to a broader-based basket of domestic and international goods and services.
It is our view that slowing demand and tightening policy will result in significantly lower inflation rates by the end of 2023. A key question is whether inflation will fall by enough to satisfy the Fed. On that front, the key question is what the Fed will be willing to accept.
We do believe inflation will remain higher than it was during the pre-pandemic, post global financial crisis recovery, stemming from a confluence of supply and demand-side considerations.
On supply: the Russian invasion of Ukraine, China’s relatively punitive policy toward zero-Covid containment and secular transition from fossil fuels to renewable energy sources all have potential to curtail the immediate and available supply of goods and services globally.
On demand: the introduction of means-based income-replacement programs during the Covid-19 pandemic represented a potential turning point in fiscal policy activism that may have popular support in the years ahead.
Again, what is important to note is that the efforts to rein in inflation have pushed the US economy into a slowing period. Our base case is that slowing growth and still-high inflation mean we will be in a stagflationary environment for some time, and that has significant implications for portfolio construction.
Importantly, real assets typically outperform stocks and bonds during periods of lower-than-expected growth and higher-than-expected inflation, demonstrated both historically and in performance in the first half of this year. As forces behind inflation persist – high commodity prices, tight labour markets, high housing costs – the odds of remaining in a favourable regime rise.
Key questions remain for our portfolio managers: How much of a hard landing scenario is priced into markets? And how should this factor into positioning, given the macro environment as well as valuations – many of which have been driven down significantly?
John Muth is a macro strategist at Cohen & Steers. The views expressed above should not be taken as investment advice.