International | Jul 26 2023
Will the global economy suffer a hard or soft landing, or none at all, in regards a recession, and how are investors setting for the outcome?
-Wall Street rally continues
-Rates nearing peak
-Hard, soft, bumpy, smooth, rolling, or none of the above?
-Setting equity positions
By Greg Peel
Since the start of June, the US stock market has moved notably higher (+8% as of last week), notes Longview Economics. With that, there’s been a broadening of participation in the rally, with cyclicals starting to outperform. To that date, the equal-weighted S&P500 cyclicals index generated higher returns (+10.5%) than the equal-weighted growth sectors (+9%), with defensives lagging notably behind.
A driver of that rally has been a growing feeling among investors the long-awaited US recession may not occur, at least in the near term. Since the Fed started hiking its funds rate at a rapid clip last year – proven now to be the fastest pace ever – investors have assumed a recession to be inevitable.
For a long time, Fed funds futures were pricing in Fed rate cuts as early as the second half of 2023, which we’re now in, as the central bank responded to said inevitable recession.
Fed rate cuts are no longer priced in.
If the US is to have a recession, it will be the most anticipated recession in history, or so the current market narrative goes.
If one takes two quarters of negative growth as confirming a recession, then one is yet to occur on that basis. If one waits for the official US caller of recessions, the National Bureau of Economic Research, that call is typically made up to eighteen months later. So much later as to be completely meaningless.
A view becoming more common is that the US has been, or is, in a “rolling recession”, in which different sectors see contraction over different time periods. For example, developed markets consumers went into a frenzy of buying goods, such as electronics and homewares, during covid lockdowns. Once lockdowns ended, and consumers had been satisfied, pent-up demand for services ranging from holiday travel to elective healthcare was unleashed.
Today, manufacturing purchasing managers’ indices (PMI) remain in contraction, globally, while services PMIs are showing growth. This suggests manufacturers, along with goods retailers, are suffering negative growth, while service industries are booming. A recession in part.
Aviva Investors notes the divergence between global services and manufacturing is currently at its greatest in the decade that such data are available.
Otherwise, the common debate is as to whether the US will suffer a “hard landing”, or deep recession, a “soft landing”, or mild recession, or indeed “no landing”, or no recession.
In the latest Bank of America-Merrill Lynch fund managers’ survey for example, notes Longview, 68% of respondents said they expect a soft landing in the next 12 months, 21% expect a hard landing, with 4% expecting no landing.
Relative to recent months and earlier this year, those percentages have changed notably. Despite that, institutional investors remain bearish (in aggregate) on equities, in contrast to retail investors who have again become notably bullish, notes Longview.
Yet fund managers who went into 2023 underweight equities are day by day being forced to revaluate their stance, as the Wall Street rally rolls on.
Consensus now has US corporate earnings reaching a bottom in the June quarter, with 2024 shaping up to show a return to growth.
Disinflation has now broadened out from emerging to G10 nations, suggesting to Citi the Fed may soon be done with rate hikes. The risk of severe liquidity withdrawals due to the US Treasury having to rebuild its coffers once the debt ceiling issue was resolved has also disappeared, Citi notes.
Equities have climbed the proverbial “Wall of Worry” and are now somewhat overbought. But with the AI story continuing, Citi would be buyer on dips.
More “Landings”
Invesco’s base case anticipates a relatively brief and shallow economic slowdown as inflation continues to moderate and monetary policy tightening nears an end, followed by a recovery. Invesco call this a “bumpy landing” because there will continue to be some economic damage in this scenario.
The analysts still believe there is the possibility of a downside scenario – a hard landing – in which global growth is hit harder, with a recession in the US which then cascades into other economies. But Invesco also believes there is the possibility of an upside scenario – a “smooth landing” – in which monetary policy impacts growth less than expected and the global economy remains relatively unscathed.
Invesco continues to believe the US is likely to avoid a substantial broad-based recession. Instead, the analysts expect some weakness in the second half of this year as policymakers accomplish a bumpy landing, but anticipate activity will nevertheless remain relatively resilient. As we enter 2024, Invesco expects a more positive growth outlook to unfold as the economy recovers.
The UK and Europe are likely to follow a similar pattern, but with a lag, Invesco suggests. China’s reopening is largely benefiting the services component of the economy while slowing growth momentum globally has meant weaker than hoped manufacturing activity. Nevertheless, China remains a bright spot, Invesco believes, with subdued inflation and a robust growth outlook, supported by continued accommodation (stimulus) from the PBoC through the rest of 2023.
Invesco’s conclusion is we are at a policy peak, disinflation is underway, and a relatively brief global economic slowdown is occurring, but markets are likely to soon look past this episode and begin to discount a future economic recovery.
But Before Then
Aviva Investors believes the medium-term balance of risks to the US growth outlook is to the downside, with the probability of a deeper downturn, that results in activity contracting and unemployment rising more materially, being close to 50%. The pass-through of the rapid tightening in monetary policy over the last year is not yet complete. As mortgage holders refinance onto higher rates, the impact on household cashflow will become more acute.
There has already been some tightening in credit availability, but Aviva expects more to come as banks take a more prudent attitude towards new lending. While the events that led to bank failures in the US in March have not spilled over into a broader banking problem, risks remain, particularly for those with large commercial real estate exposure.
Finally, the excess savings that supported the post-covid recovery in household consumption are unlikely to provide much ongoing support as they are likely now exhausted in real terms.
The fall in energy prices from their peak, around -25% and European gas prices down -75% from their 2022 average, has resulted in headline CPI inflation starting to fall sharply. Aviva expects headline inflation rates to continue to fall, as the contribution from energy turns negative, and the pass-through of lower energy prices into fresh food and manufactured goods should also help to bring headline inflation down.
However, while the energy effects dominate headline inflation rates, core inflation measures remain uncomfortably high.
That strength in underlying inflation reflects ongoing tightness in labour markets, elevated wage inflation and companies being able to maintain their margins.
There is evidence margins are starting to compress, notes Aviva, which should help to ease core inflation pressures. However, the period of below-trend growth and higher unemployment in the analysts’ central projection will be required in order to deliver softer wage growth and ultimately lower underlying inflation pressures.
Ask a Model
Given June’s strong Wall Street performance (continuing through July), Longview Economics admits it moved tactically Underweight equities too early in the uptrend. The models are increasingly, though, generating a clear Sell message. Technically the market is overbought on various levels (and by various measures), according to Longview’s analysis.
Risk appetite is high and scoring systems are on or close to Sell, while market participants are vulnerable to negative newsflow being unhedged (put option protection is low). Added to which the cyclical (as well as the growth) part of the market is overextended to the upside, while the defensive area is the most attractive top level segment (on various measures) – which is typically a bearish sign for the stock market.
Longview thus believes a continued Underweight equity position is logical. It remains Overweight bonds, given its views on rising deflation risks (and expectation of a recession) and that the Fed is close to finishing its hiking cycle.
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