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US recession: what recession?

02 March 2023

The tide is most definitely starting to turn, giving investors with US holdings some hope.

By Darius McDermott,

Chelsea Financial Services

Recession, what recession? That is the question now on every US market watchers’ lips. Oh what a turnaround. Up until recently the outlook was all doom and gloom. But what a difference a few weeks and some data updates can make.

At the start of 2023 several economic indicators in the US suggested a recession was probable this year. These included the inversion of the yield curve since October and the extent of the decline in the Index of Leading Indicators, which is used to predict the direction of global economic movements.

Another measure with a good track record of predicting US recessions joined them in January when the ISM Manufacturing New Orders index fell to 42.5, down from 45.1 in December, and down from 57.9 one year ago.

However, the tide is most definitely starting to turn, giving investors with US holdings some hope and new money a possible home in America.


What has changed?

This change of heart has been prompted by much stronger than expected data for January, which is only now filtering through. Following hard on the heels of a surge in employment and rise in business confidence, was news of a 3% jump in retail sales.

Retail investors have also been a major force behind the rebound and appear firmly in the soft-landing camp. This leaves US growth starting the year on a firm note and casts doubt on the notion that the economy is headed into recession.

The unusually warm weather may well be partly behind some of this unexpected strength but even so, an imminent nosedive now looks unlikely.


Long-term prospects for investors

Short-term data is one thing, but investors rightly need longer-term prospects to entice them in. Bob Kaynor, fund manager of the Schroder US Mid Cap, says the US has that too.

He pointed to a combination of a strong backdrop for the US consumer, government spending on infrastructure and social bills, and corporate capital expenditure, as leading to higher US growth over the next few years.

He said: “This growth will be broader based and focused on de-risking supply chains, automation to tackle dependence on a tight labour market, and emerging areas of the market to address climate risk.”

In this environment, US small and mid-cap companies are set to benefit more than in the past, he added, partly due to the greater choice of companies participating in the domestic US economy, as well as beyond.

He said: “The focus will be on earnings and cashflows. Conservative guidance for fourth quarter earnings was similar to 2018 but the difference in 2023 is that the Fed will not be cutting interest rates in a hurry.

“The good thing is after years of underperformance versus large-caps, valuations for small and mid-caps are already pricing in a lot of risks. We believe this will partly support a change in leadership over the next few years from large-caps to mid and smaller companies.”


What about inflation?

The future, however, is not as easy as it sounds as higher growth prospects come with the risk of more cost inflation. US inflation fell less than expected in January, with the headline and core rates both down only slightly at 6.4% and 5.6% respectively.

The former is well down from a high of 9% but these numbers suggest the retreat of inflation is unlikely to be as fast or as smooth as markets had come to expect, especially because last week’s report from the Commerce department also showed that consumer prices 0.6% from December to January, up sharply from a 0.2% increase from November to December. Core inflation looks likely to end the year still well above the Fed’s 2% target.

Wage pressures will be more persistent as both skilled and unskilled labour remains scarce. Companies that can protect profit margins will be the biggest winners.


A return to fundamentals?

Taymour Tamaddon, manager of the T. Rowe Price US Large Cap Growth Equity fund, said, while macroeconomic noise and general sentiment have been major driving forces in the market of late, an eventual return to company fundamentals is due.

He said: “We are likely in the latter innings of the unwind in growth stocks. Now it is becoming a question of what is priced in as we look at earnings.

“Markets are likely to remain volatile this year given the regime shift and ongoing macro uncertainty. That said, we think there are attractive long-term growth opportunities available at reasonable valuations in names like Fiserv, Intuit, and Becton Dickinson.”

His highest conviction sectors are healthcare and communication services. In healthcare, he remains focused on opportunities around lasting trends – such as managed care industry consolidation, innovations in medical equipment, and robotic technology.

In communications services, he continues to hunt for companies benefiting from the shift of advertising spending to digital and social media channels, as well as disruptive forces within entertainment.

The Baillie Gifford American fund invests in growth companies which have been indiscriminately sold off over the past 18 months as interest rates have been increased to combat inflation.

Tom Slater, the fund’s manager, said in many cases the businesses held within the portfolio have made“good and sometimes great operational progress over the period, but this has not yet been broadly recognised in share price terms, although prices of some key stocks have bounced since the turn of the year”.

The Baillie Gifford American fund invests on a five-to-10-year view so the manager is loath to place any weight on short-term data or market moves, saying the “price of the fund could change materially based on the valuations of a few companies…we will not attempt to predict or control for short-term price changes”.

His investment horizon of at least five years, he says, helps him see value where others don’t, with an important caveat: “We cannot guarantee that we will be proven right.”

While the US economy looks to be on a much better footing than a few weeks ago, with inflation still running high and the Fed still eyeing rate rises, I reserve the right to the same caveat. Two economists I’ve seen in the past two weeks are still very much predicting recession – it may just be that it’s later in the year or next when the impact of the rate rises take finally take hold.

Darius McDermott is managing director of Chelsea Financial Services & FundCalibre. The views expressed above should not be taken as investment advice.

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