Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

Economist Milton Friedman famously noted that “monetary actions affect economic conditions only after a lag that is both long and variable.” ¹ The current cycle is following this maxim. We have seen the most aggressive tightening by the U.S. Federal Reserve (Fed) since the early 1980s, yet payroll gains have averaged 407,000 over the first two months of this year and consumer spending growth is running close to trend.

European and Chinese growth have also surprised positively. The energy shock from the Russia/Ukraine war was supposed to send Europe into recession over the northern winter, but growth has remained positive. The unusually warm winter has boosted economic data in the U.S. and Europe, but there are also fundamental factors at play. Consumers in both regions are benefitting from falling energy prices, job gains and improving real incomes. China is bouncing back following the easing of COVID-19 lockdowns.

It would be unwise, however, to sound the all-clear on the global growth outlook. Those long and variable lags are still in play. Historically, it has taken an average of around two and a half years after the Fed’s initial rate hike for a recession to commence. The first hike in this cycle was in March 2022.

The collapse of Silicon Valley Bank (SVB) in mid-March highlights the dangers from aggressive central bank hikes. SVB’s main problem was its large holding of long-duration bonds, which lost value as bond yields rose through 2022. It bears little resemblance to the bank failures during the financial crisis in 2008. These were mostly due to losses on mortgage-backed securities. The Fed’s new Bank Term Funding Program should prevent SVB’s problems from flowing onto other banks, but the episode highlights the dangers caused by rapid monetary tightening.

The economic data renaissance combined with the threat of financial sector instability leaves central banks with difficult choices. High inflation means more rate hikes are likely, but worries about financial stability argue for moving cautiously. The banking system shock should also act as a form of monetary tightening through tighter lending standards. We expect that the Fed will undertake one to two more 25-basis-point rate hikes in the next few months.

Every cycle is different, but this one stands out because of the pandemic, which disrupted supply chains and pulled forward goods demand during the lockdowns. Labour markets tightened quickly due to worker shortages caused by early retirement, increased long-term illness and lower immigration. Large government support packages meant U.S. consumers were sitting on more than $2 trillion of additional savings when lockdowns were eased in late 2021. Add on the energy shock from the Russia/Ukraine war and the result is an inflation spike that has been larger and more persistent than most forecasters anticipated.

When could a recession strike the U.S.?

Our view is that a mild recession in the United States is likely over the next 12-18 months. The inverted yield curve is the indicator that most clearly signals recession risk. The chart below shows the spread between the 10-year and 2-year Treasury yield. A negative spread (inversion) means that bond investors think the Fed has tightened by so much that interest rates will be lower in the future.

Strong household and corporate finances are likely to limit the downturn to a mild recession. A mild recession, however, implies that the cycle will be a headwind for equity markets as earnings and economic indicators deteriorate. It is a more favourable environment for government bonds, which should provide investors with good diversification potential.

The overheated labour market is the biggest imbalance in the U.S. economy. Wage inflation has spiked to a 40-year high and there are a record two job vacancies for every unemployed person.

How far does the Fed want wage inflation to fall?

The Fed will only back off from restrictive policy when it is confident the labour market has cooled by enough to bring wage inflation into line with its 2% target for consumer price inflation. Most wage measures are running at around 5-6% annual growth. The Fed would prefer wage inflation to be below 4%.

The unemployment rate at 3.6% in February is the lowest since the 1960s. We estimate that it needs to rise by at least a percentage point to generate the cooling in wage growth required by the Fed. Unemployment, however, tends to continue rising once it starts to go up. Households respond to rising unemployment by cutting back on consumption. Businesses trim investment spending. The resulting fall in aggregate demand leads to higher unemployment and less spending. Over the post-World War II period, the U.S. economy has experienced a recession every time the three-month moving average of the unemployment rate has risen by more than a third of a percent.

The Fed faces a daunting task to achieve a soft landing that sees wage growth and inflation cool without causing a recession. Equity investors may cheer the initial signs of labour-market cooling on hopes for a Fed pivot. Historical experience, however, suggests that the landing will be difficult to accomplish.

When unemployment begins rising, it usually continues rising

Source: Refinitiv® DataStream®, as of 23 February 2023.

Corporate earnings are another watchpoint for investors this year. Earnings growth peaked in most regions in early 2022 and has trended lower since. This has in part been due to moderating sales growth as economic growth cools, but falling margins have also played a role. Margins were boosted by rising inflation during 2021 and early 2022 as final pricing power improved, but cost inflation, particularly labour costs, remained subdued.

What are the expecations for earnings growth?

That process, however, has been in reverse over the past year. Declining inflation means firms are losing pricing power, but labour costs are declining more gradually. The chart below shows the 12-month-ahead consensus earnings expectations from the Institutional Broker Estimate System (I/B/E/S). Industry analysts have become more cautious on the earnings outlook for the next year but are not yet anticipating the 15-20% decline in earnings per share (EPS) that typically occurs during a recession.

Forward price-to-earnings multiples have declined significantly over the past two years (the S&P 500® multiple has fallen from 23X to 17X), so to some extent, investors have already factored in a decline in earnings. The current round of surprisingly strong economic data could see earnings growth expectations track broadly sideways for the next few months. A further downturn in earnings expectations seems likely, however, as the Fed achieves its goal of reducing inflation by slowing demand.

Our cycle, value, and sentiment (CVS) decision-making process points to an uncertain equity market outlook and is more favourable on the outlook for government bonds.

Is the business cycle a headwind for equities?

The cycle outlook (with recessions likely) is a headwind for equity markets. This may improve once it is apparent that the Fed has finished tightening. The turning point will come when interest rate cuts are on the horizon.

Equity market valuation is a question mark. The one-year forward price-to-earnings (PE) multiple for the S&P 500 has fallen from 22 times at the beginning of 2022 to 17 times in mid-March 2023. This, however, is still a high multiple by historic standards. Our valuation methodology scores U.S. equities as expensive. Non-U.S. equities are closer to fair value.

Our composite sentiment indicator for equities is marginally oversold as of mid-March. It had moved to slightly overbought early in the year as equities rallied but reversed on the market volatility following the collapse of Silicon Valley Bank. We judge sentiment as neutral for the outlook.

Composite contrarian indicator signals slightly oversold investor sentiment

Source: Russell Investments. Last observation is +1.42 Standard Deviations, as of 15 March 2023. The Composite Contrarian Indicators for investor sentiment is measured in standard deviations above or below a neutral level, with positive numeric scores corresponding to signs of investor pessimism, while negative numeric scores correspond to signs of investor optimism.

The CVS conclusion for equities is that the cycle is poor, value is expensive to at best fair value and sentiment is neutral.

Are government bonds attractive?

Government bonds are attractive from a CVS perspective. The cycle is turning supportive with inflation set to decline and central banks potentially pausing in the next few months. Value is positive after last year’s selloff. Sentiment is supportive, with data from the Commodity Futures Trading Commission (CFTC) highlighting that most investors hold short-duration positions (i.e., they expect yields to rise). This is supportive from a contrarian perspective.

Specifically, we have the following asset class assessments at the beginning of Q2 2023:

• Equities: Limited upside with recession risk on the horizon. Although non-U.S. developed equities are cheaper than U.S. equities, we have a neutral preference until the Fed become less hawkish and the U.S. dollar weakens.
• Emerging market equities: Tracking the performance of the U.S. dollar and a recovery seems likely only once the Fed has stopped tightening and the U.S. dollar begins to decline. China’s reopening has helped Chinese stocks rebound, but there are question marks over the longer-term outlook given the headwinds from the property market. For now, a neutral stance is warranted
• High yield and investment grade credit: Spreads have widened following the turbulence caused by the Silicon Valley Bank collapse and are above their long-term averages. Spreads will come under upward pressure if U.S. recession probabilities increase and there are fears of rising defaults. We have a neutral outlook on credit markets.
• Government bonds: Valuations have improved after the rise in yields during 2022. U.S., UK and German bonds offer reasonable value. Japanese bonds are still expensive with the Bank of Japan holding the 50-basis-point yield limit. Our methodology has fair value for Japanese government bond yields at around 100 basis points. The risk of a significant selloff seems limited given inflation is close to peaking and markets have priced hawkish outlooks for most central banks.
• Real assets: REITs valuations remain attractive relative to infrastructure and global equities, although the gap has become smaller. REITs should perform well when interest rates fall, given that real estate fundamentals appear reasonably healthy. Commodities should benefit from the China reopening. The boost is likely to be smaller than for previous China rebounds since infrastructure/construction is expected to drive less of the growth in 2023. The energy outlook is murky, given the demand destruction from potential global recession and the supply constraints from the sanctions on Russian output. Gold looks fully priced, given its relationship to real interest rates and with inflation risks diminishing.
• U.S. dollar: The dollar has risen modestly this year on Fed hawkishness. It could weaken if inflation begins to decline and the Fed pivots to a less hawkish stance. The main beneficiaries are likely to be the euro and the Japanese yen. The yen could also appreciate strongly if new BoJ governor Kazuo Ueda moves away from the current yield curve control strategy.

Asset performance since the beginning of 2023

Source: Refinitiv® DataStream®, as of 14 March 2023.