Earlier this summer, we restated our base case that there would be no US or global recession in the next six to 12 months. However, I also said that we couldn’t shy away from the risks and that we were seeing more ‘yellow flags’ in the data.
Our stance had become iteratively more cautious since June 2021 and – particularly from the first quarter of this year – we have recommended staying invested yet defensively positioned given the broadening risks. If the facts change, I said, we would change our minds, just as we have done over the previous 12 months.
In the six weeks since, the facts have changed. Those warning flags in the leading indicators of economic activity have multiplied, while some of the yellow ones have turned conspicuously red.
GDP isn’t the final word
It’s worth clarifying that we don’t believe that the US – the bellwether for global investment markets – is currently in any helpful definition of recession. While US GDP contracted in the first and second quarter (a shorthand for recession), it was heavily influenced by unusual trade patterns and swings in inventory.
However, that’s little comfort when leading indicators of activity suggest that the risk of the US entering an ‘official’ recession before long has increased considerably. Using a variety of signals we estimate a probability of between 55% and 66% of the US being in recession at each time horizon from one to six quarters ahead.
Such econometrics are only ever a starting point. We can think of reasons why some of the indicators individually may be giving misleading signals. But the deterioration in the data is just too broad-based to be ignored. It encompasses the consumer, the jobs market, private investment, residential construction, the supply and price of money, and energy costs. To say they are all sending misleading signals is pushing it.
However, it's important to stress that while the chance of a US recession is high, it is not a foregone conclusion. And if one does arrive, it’s highly likely to be a relatively mild one by past standards. Anchoring our expectations for what a recession would mean for investors to what happened in 2008 could be misguided and it’s important to understand both upside as well as the downside risks.
Risks elsewhere
The risk of a deeper recession is much more pronounced in Europe, however, where we’ve been flagging a greater than 50% probability of contraction for some months now. Second quarter GDP growth was remarkably resilient in the Eurozone, thanks to a very strong tourist season in the south and a long-awaited rebound in spending on socialising in the north. However, the price of energy and attendant cost-of-living crisis make that unlikely to continue.
The situation in the UK is a little better, but not much. Another rise in household fuel bills is likely to push inflation up to over 15% by the start of winter, far eclipsing the growth in average take-home pay.
For an economy with a dismal record on business investment relative to its peers since 2016, and one which today has a lower standard of living than before 2008, it is disappointing that the Conservative leadership contest has been so devoid of new ideas.
The notion that cutting already-competitive tax rates (particularly income taxes) provides a boost to growth beyond the short term was popular in the 1970s when there was little else to go on other than the leading abstract theories of neoclassical economists.
But since then, economics has undergone an empirical revolution that has revealed economies are rather more complex. Today, we need policies that take account of the real world. Of course, finding any party in the UK with learned, new ideas is rather a tall order, and we certainly don’t want to single out this government.
The path of inflation
We’re confident that core inflation will fade rapidly across the globe next year. The San Francisco branch of the US Federal Reserve estimates that between half and two-thirds of headline American inflation is driven by supply constraints.
Similarly, we calculate that two-thirds of US inflation is coming from energy, food or categories of goods that had outsized demand during lockdowns and supply chains that failed to keep up. In the Eurozone it’s over 80%. Crucially, these forces are abating as the demand for consumer goods is falling sharply to more normal levels, and supply chains are becoming unblocked.
However, inflation pressures in consumer services are broad. Nominal wage growth may need to slow from 5-6% now to 3-4% to give inflation a good chance of getting back to normal next year. The labour market indicators with the most predictive power over wage growth point to it only edging down in the next few months, so more progress is required.
This fall in wage growth could take time and the longer inflation remains elevated (as it will in the UK due to energy prices) the greater the risk that wage growth remains high. While the fact that wage inflation is lagging so far behind price inflation means a repeat of the 1970s is unlikely, we are concerned that the market has become too complacent about how quickly inflation could fade.
Central bankers’ agenda
This means that there is a concomitant risk that investors are wrong to have priced in policy rate reversals during 2023.
Given that changes in government bond yields have been very strongly correlated with what central bankers have done relative to market expectations, the risk of a delay to the first rate cut (which in the US is expected from around March 2023) means that bonds could fall in value.
This risk also means that the technology and other so-called ‘growth’ stocks that have led the equity rally in July may not continue to outperform. This isn’t what usually occurs as we enter recession. If the recession is deeper or longer than anticipated, we expect disinflationary forces to dominate, making bonds a better investment to defend against this scenario.
We are less certain about the risks around the path of UK interest rates. The Bank of England has made some serious communication errors during the past year. The rhetoric from Governor Andrew Bailey has been notably more inflation-busting of late.
But the projections made within the latest Monetary Policy Report somewhat belies the chief’s speeches: the medium-term inflation forecasts are among some of the weakest ever made. Even if they assume interest rates rise no further, the Bank suggests inflation could fall well below forecast on a three-year horizon.
What does all of this mean for equities and our long-term multi-asset portfolios?
It is still important to weigh some reasons to be optimistic about market prospects against the more on-the-nose pessimistic ones. And in many cases prices have fallen this year to a point where much – although likely not all – of what I’ve just discussed may already be factored in.
Still, there has been no major downgrade to earnings expectations, with the consensus continuing to anticipate solid growth this year and next in most major markets and across most sectors. Of course, we think the US and global recessions would be mild, and therefore it may only require a few percentage points to be shaved from these expectations. But the risks are skewed to the downside.
Changes in stock prices tend to pre-empt changes in earnings expectations by around six months. Perhaps they have done this time too. There’s considerable evidence that institutional investors have already sold a lot on the pessimism felt in the first half of the year. However, some of this positioning reversed in July.
Meanwhile retail investors do not appear to have adjusted their positioning by anything like as much yet and it is here that the risk of further capitulation is most acute if a recession begins and inflation stays sticky.
All told, we recognise both upside and downside risks, but place more emphasis on the down at present and recommend continuing with a substantial bias towards defensive, inflation-resilient companies.
We prefer cash to government bonds, at least at this stage of slowdown, given the potential overestimation of the rate at which inflation will fade, and look to our strong track record in identifying alternative diversifying assets.
Ed Smith is co-CIO at Rathbone Investment Management. The views expressed above should not be taken as investment advice.