It seems markets are increasingly hopeful that Goldilocks is back; that the economy can avoid recession with inflation falling back to target…to us, however, this feels a little too good to be true.
Our year ahead outlook was titled ‘2023: A bad year for the economy, a better year for markets’. The prognosis was simple: a recession would be required to get rid of inflation. The only question was how high interest rates would need to get to generate that recession. Central banks had flagged their intentions, meaning most developed world stock markets had already tumbled last year, so we felt that markets were well braced for the economic downturn ahead.
Fast forward six months and it is indeed proving to be a better year for markets. But it is also turning out to be a better year for economies than we had envisaged. While manufacturing has suffered through the combination of weaker demand for goods and soaring costs, service sector activity remains remarkably robust. A strong labour market, pent-up savings and a desire to make up for the experiences missed during Covid appear to have outweighed the drag from higher costs and interest rates.
Yet the resilience of growth hasn’t led to market expectations of an extended period of higher interest rates. Instead, the debate in the bond market has been centred around how quickly rate cuts will be delivered.
It seems markets are increasingly hopeful that Goldilocks is back; that the economy can avoid recession with inflation falling back to target.
Inflation is priced to fade quickly, allowing central banks to shift their attention to supporting growth. Instead of driving a recession, they will be aiming to prevent one, which would be music to both stock and bond investors’ ears.
To us, however, this feels a little too good to be true. There are a number of questions that are still outstanding and will need to be answered in the remainder of the year. Running through these issues, we conclude that interest rates won’t be slashed pre-emptively and therefore a recession is still more likely than not. If rates are being slashed, it’s probably because a recession has occurred which could trouble risk assets.
For that reason, in this mid-year outlook we focus on a) ensuring a portfolio is well diversified against both recession and inflation risk, b) allocating to stocks in a relatively defensive fashion, and c) the secular themes that to us seem increasingly dominant as we shift from a world of abundance to scarcity.
What will the economic toll of recent banking stresses be?
Three large bank failures in the US and the Credit Suisse rescue in Europe were seen by markets as a reflection of growing tensions in the banking sector. But after a short spike in volatility in March, risk aversion in markets retreated as swift liquidity support by central banks and takeovers prevented an escalation. However, we think market perception is probably too complacent in this respect. While we acknowledge that banks are significantly better capitalised and regulated than 15 years ago, first quarter lending surveys in the US and eurozone reminded us how banking troubles can spill into the broader economy.
Bank lending surveys highlight that almost 50% of US commercial banks and nearly 25% of banks in the eurozone had already tightened corporate lending standards in the first quarter. In the past 30 years, this level was usually accompanied with a recession. Higher macro risk, lower risk tolerance, and balance sheet constraints are seen as main contributors to recent tightening of lending conditions. This is unlikely to change in the near term since a bleak outlook for housing and commercial real estate, and a downturn in the credit cycle will likely keep risk tolerance at banks low for the time being.
Balance sheet constraints caused by unrealised losses and deposit outflows will ease as soon as interest rates fall. A scenario of a fast cooling in core inflation would be the best case in that respect, giving central banks room to lower policy rates which would also translate into looser credit conditions. Unfortunately, we don’t expect inflation to disappear quickly enough.
Will businesses cut jobs in the face of slowing earnings?
Another uncertainty is how the labour market behaves. Usually when profits come under pressure, firms quickly cut back on investment, and then staff, in a bid to repair margins. This then marks the start of a vicious cycle as higher unemployment leads to a further downturn in demand, profits and so on.
There are already signs that firms are cutting back on investment plans but employment intentions remain relatively robust. This might reflect the fact that firms have had such a tough job finding staff post pandemic and hence are willing to hoard staff in the hope that the downturn is short lived.
It’s also possible that this is a temporary phenomenon and a significant rise in unemployment is around the corner. For now, central banks face a difficult balancing act. They need the labour market to weaken to drive down wage growth and inflation, but being the cause of rising unemployment is never something central bankers relish. Having to deliver that outcome in the run up to a national election, as will be the case in 2024 for the UK and US, makes life even more uncomfortable.
Will inflation cool on both a headline and core basis?
Headline inflation is likely to continue retreating in the coming months and Europe will benefit from favourable base effects as the large gains in energy and food prices seen this time last year start to drop out of the annual calculation.
We are less convinced, however, that core inflation is on a speedy path back to 2%. Demand for services remains buoyant with households still seemingly intent on making up for the lost experiences in Covid times. The tightness of the labour market and ongoing pressure on wages will also keep upward pressure on cost and prices until a recession hits.
Stepping back from the short-term drivers, our main concern is that we struggle to see a world in which goods price inflation will be as low and stable as it has been in the past. The US consumer paid the same for the basket of goods that they bought in 2020 as they did 20 years earlier. For the UK consumer it was the same 30 years earlier. With the combination of higher input costs as we transition from fossil fuels and less of a disinflationary drag from globalisation, we struggle to see such a feat being repeated.
If goods price inflation ends up being higher on average then central banks would have to drive services inflation lower if they are serious about meeting their 2% targets sustainably. It’s worth remembering that the last time US service sector inflation dipped below 1% was on the back of a very deep recession. The economic cost of such an endeavour makes this a politically unrealistic outcome in our view. For governments, a little unanticipated inflation also appears an easier way out of a debt problem, having already exhausted the option of austerity. Latest surveys of inflation expectations suggest we are not alone in our suspicions that higher medium-term inflation is on the cards. If central banks cut rates later this year prior to the onset of a recession, it would strengthen our conviction yet further that investors should prepare their portfolios for both higher inflation on average over the medium term and more frequent bouts of inflation volatility.
Will Europe have energy problems next winter?
Europe confounded expectations of an economic meltdown over winter, having lost its biggest supplier of energy last July. In fact, warmer temperatures, curtailed industrial production and some efficient shifts in behaviour meant that storage tanks remained unseasonably full. Plummeting wholesale gas prices are now helping to drive down inflation and revive consumer confidence.
Pessimists might argue this was more luck than judgment which would have to be repeated next winter. But the starting point is so strong the race is already half won; EU storage tanks are at over 70% capacity which compares to just over 50% this time last year. The price of gas on short-term contracts has fallen but even prices further ahead suggest next winter is looking increasingly secure unless temperatures are particularly severe. All the while the race is on to ensure that a domestic renewable solution is in place. We are generally optimistic that energy prices won’t surge again.
Will China’s recovery be short-lived?
After the end of zero-Covid, China’s recovery showed similar patterns to those seen in the US and Europe before. Sentiment in the service industry improved significantly as Chinese consumers caught up with activities they had to forego in the lockdown period. However, investment activity was relatively muted compared to previous recovery cycles as global goods demand weakened and domestic credit growth was less expansionary.
Second quarter business sentiment indicators now point to weaker growth momentum ahead as real estate woes are still taking their toll on private sector confidence and post-pandemic financial buffers are not as extensive as in Europe or the US.
While we acknowledge that Chinese growth in 2023 might fall short of relatively sanguine market expectations at the start of the year, it would be premature to write off the entire year. Moderate government debt levels give policymakers room for additional fiscal stimulus, while very low inflation is allowing the People’s Bank of China (PBOC) to cut policy rates to support household and corporate balance sheets.