Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

Markets had stabilised somewhat over the past three months, but 2022 remains an annus horribilis¹ for investors with both equities and government bonds posting negative returns so far this year. Investors remain worried about high inflation, slowing growth and the potential for an aggressive Fed to cause a recession.

It’s hard to find much good news, but one source of comfort is that investor sentiment is very negative, providing some reassurance that markets have already accounted for the bad news. Our composite sentiment index, which measures investor sentiment for the S&P 500® Index via a range of technical, positioning and survey indicators, is near two standard-deviations oversold.

Are the chances for a U.S. recession increasing?

It’s too early to predict that a recession is the most likely outcome for the U.S. economy during 2023, but the probability is rising. The main warning comes from the inverted yield curve, where the spread between the yields on the 10-year and 2-year Treasury bonds is the most negative in 40 years. Some of the leading indicators for the U.S. economy, such as the Institute for Supply Management’s index for new orders, have softened. The indicators that the Fed is focused on, such as payrolls and wages, remain overheated. These labour-market trends tend to lag the broader economy. This creates the risk that the Fed will continue to tighten even as the economy weakens. It also means Fed Chair Jerome Powell is unlikely to navigate a pivot to a less hawkish stance before early in 2023.

Recession, however, seems unavoidable for the eurozone and UK, where surging prices for natural gas are hitting hard. China’s economy remains weak, but stimulus is happening, albeit gradually. The end of China’s resurgent COVID-19 lockdowns, hopefully by early next year, should allow growth to recover.

What type of recession could the U.S. see?

We’re still in the soft/softish landing camp for the U.S. and expect that strong household and corporate finances can limit the downturn to, at worst, a mild recession.

The arguments against a deep U.S. recession are that household and business balance sheets are in good shape, and moderating inflation could drive a recovery in real spending power. This outcome, however, relies on the Fed slowing the pace of tightening and pausing at only a moderately restrictive level.

We expect inflation to trend lower over coming months, which along with signs of softer growth, should allow the Fed to pause once the target rate is around 4%-4.5%. Fed tightening phases, however, are usually anxious times for markets. Investors are likely to worry about excessive monetary tightening and the risk of a more severe recession. It’s possible that the mid-June lows for equity markets will be re-tested, and markets are likely to remain volatile until inflation is clearly trending lower.  

Inflation has remained stubbornly high during 2022. This has been partly due to high energy costs caused by the Russia-Ukraine war. It has also been the result of cost pressures generated by pent-up demand as economies re-opened from lockdowns and firms scrambled to hire staff to meet this demand.

Global core inflation rates

Source: Refinitiv® Datastream®, as of August 22, 2022. Core inflation is calculated minus the food and energy components, which tend to be more volatile and prone to inflationary spikes. YY indicates year-over-year.

Inflation should be on a downward trend across developed economies over the next few months. For headline inflation, this requires that oil and natural gas prices at least stabilise at current levels. Oil prices have already fallen around 30% from their post-invasion peak in March. Natural gas prices have also fallen and should remain contained now that Europe has managed to fill gas storage to almost 90% of capacity ahead of the northern winter.

Has core inflation peaked?

Core inflation, which excludes food and energy costs, is close to peaking in most regions. Measures of supply chain bottlenecks have eased, and industrial commodity prices have trended lower over the past few months. Prices for durable goods, such as automobiles, home appliances and computers, have been the biggest cause of rising core inflation. Demand for these goods shot up during the pandemic while supply-chain blockages restricted supply. Durable goods tended to fall in price before the pandemic and are likely to resume declining as supply chains normalise and demand rotates from goods toward services. These disinflationary forces should allow core inflation in the United States to fall from over 6% currently to 3.5%-4% over the next several months.

The issue for central banks, however, is whether inflation can return close to 2%. This will require a slowdown in employment creation and for wage growth to cool from the almost 7% current annual rate of increase in the United States. The monetary tightening so far should ease labour demand over the coming months, but central banks will want evidence that the jobs market is slowing before backing off from rate hikes.

Natural gas accounts for about a quarter of Europe’s energy supply. Before the war, around 40% of that gas came from Russia. The natural gas price was averaging around €16/megawatt hour (mwh) in the five years to 2020 before surging to around €200/mwh currently. This is the equivalent of oil prices rising to $600 per barrel. This magnitude of energy-price shock makes a recession almost inevitable. European governments have tried to offset the shock by filling gas storage, securing new sources of supply (Europe is now the United States’ biggest market for liquid natural gas), postponing the shutdown of nuclear power plants and restarting coal-fired power plants.

How are European governments responding to the energy crisis?

Nearly €400 billion in government support measures have been announced and more packages seem likely before households are hit by surging winter heating costs. The additional headwind, however, is that monetary policy is heading in the other direction. The European Central Bank (ECB) has lifted rates twice since July to 1.25%. Financial markets expect the policy rate to peak at 2.5% in early 2023. This is around one percentage point above our estimate for the neutral policy rate in Europe.

What type of recession is the UK facing? What about continental Europe?

The outlook is more precarious for the United Kingdom, where natural gas accounts for 40% of energy use. Inflation pressures are stronger in the UK due to labour supply shortages. The Bank of England (BOE) has already lifted the policy rate to 2.25% and markets expect the rate to peak at 4.5% in mid-2023. The new prime minister, Liz Truss, is planning a support package of energy price caps and tax cuts that could amount to nearly 8% of gross domestic product (GDP). This should prevent a deep recession and soften the inflation impact.

The policy support in the UK and the energy transition from Russian gas in Europe suggest the winter recession should be relatively shallow. For Europe, this creates the potential for a spring rebound as inflation declines and the ECB pivots to a less hawkish stance. The post-winter outlook is less clear-cut for the UK. The massive Truss stimulus combined with post-Brexit labour supply shortages will have the BOE concerned about inflation becoming entrenched. The UK’s recession may not be deep, but the recovery could be disappointingly slow.

The post COVID-19 recovery, inflation surge and energy price shock have triggered large currency extremes. The U.S. dollar has benefited from Fed hawkishness and its safe-haven appeal during times of market volatility. In real trade-weighted terms, the U.S. dollar is the strongest since the Plaza Accord² era of the mid-1980s.

The euro, Japanese yen and British sterling are now significantly under-valued on a longer-term basis. The euro is 30% below its purchasing power parity value and sterling is 20% undervalued on this measure. The outlier is the yen which is 35% undervalued.

Could the U.S. dollar weaken next year?

The U.S. dollar (USD) has been on an upward trend for over a decade but 2023 might be the year that it starts to reverse. This scenario requires that inflation pressures subside, and the Fed becomes less hawkish. This same scenario should allow the euro to rebound, particularly if natural gas prices fall further. The European economy has a strong link to Chinese growth. A rebound in Chinese activity as zero-tolerance lockdowns end and more stimulus is implemented will also support the euro.

Japan’s inflation trends have lagged the rest of the world, and the Bank of Japan (BOJ)’s strong defense of its 25-basis-point limit for 10-year Japanese government bond yields has pushed the yen lower. BOJ Governor Haruhiko Kuroda’s term expires next April, and his successor may favour a shift away from aggressive yield-curve control.

The risk to this view of a peak in the U.S. dollar is that inflation pressures continue to build, and the Fed becomes more hawkish. Dollar weakness, however, will support the performance of non-U.S. equity markets, particularly emerging markets.

There was some relief for investors over the past three months with global equities posting moderately positive returns. Markets, however, were under pressure in late September as central banks continued to tighten policy and inflation remained high.

Where is the business cycle headed?

Our cycle, value, and sentiment (CVS) investment decision-making process has a neutral view on the outlook for the fourth quarter of 2022. Equity sentiment is oversold but is not at the extremes recorded in June, prior to the market rebound. In June our sentiment index reached oversold levels last recorded during the Covid-19 market panic of March 2020.

The cycle outlook has deteriorated further and is a headwind for equity markets. We’re not yet ready to predict that a recession is the most likely outcome for the U.S. economy in 2023, but the probability is rising. Chairman Powell’s address at the Jackson Hole Symposium in late August made it clear the Fed will continue to tighten monetary policy until inflation is trending lower. He was explicit that monetary policy will remain restrictive for some time.

Are equity valuations improving? 

The 1-year forward price-to-earnings (P/E) multiple for the S&P 500 has fallen from 21 times at the start of the year to 16.5 times in late September. Our valuation methodology is not scoring U.S. equities as cheap, but value has improved. This methodology, however, suggests that non-U.S. equities are now showing value.

What’s the outlook for government bonds?

The 10-year U.S. Treasury at a yield of 3.5% is screening as good value on our valuation framework. Sentiment is also positive for Treasuries with positioning indicators showing that investors are crowded into short duration positions. The cycle, however, will not be supportive of a rally until there is a good case that market expectations for Fed tightening have peaked.

The U.S. dollar has made strong gains this year. It has benefited from Fed hawkishness and its safe-haven appeal during times of market volatility. The euro, yen and sterling are now significantly under-valued on a longer-term basis. The argument for USD weakness over the next 12 months is similar to the rationale for becoming bullish on equities and bonds: inflation pressures subside, and the Fed becomes less hawkish. Dollar weakness would support the performance of non-U.S. markets, particularly emerging markets.

Composite contrarian indicator

Russell Investments. Last observation was 2.19 as of September 15, 2022. Contrarian indicators for investor sentiment give a numeric measure of variability to indicate how pessimistic or optimistic market actors are through time.

Here is a summary of our asset-class views as Q4 2022 begins:

• We have a small preference for non-U.S. developed equities to U.S. equities. They are relatively cheaper and will benefit from U.S. dollar weakness should the Fed become less hawkish.
• Emerging market equities could recover if there is significant China stimulus, the Fed slows the pace of tightening, energy prices subside and the U.S. dollar weakens. For now, a neutral stance is warranted.
• High yield and investment grade credit spreads are near their long-term averages, although the overall yield on U.S. high yield at about 8.5% is attractive. Spreads will remain under upward pressure if U.S. recession probabilities increase. We have a neutral outlook on credit markets but will become more positive if a U.S. recession becomes less likely.
• Government bond valuations have improved. U.S., UK and German bonds offer good value. Japanese bonds are still expensive with the Bank of Japan aggressively defending the 25-basis point yield limit. Our methodology has fair value for Japanese government bond yields at around 50 basis points. Yields have risen sharply in most markets in recent months. The risk of a further significant selloff seems limited given inflation is close to peaking and markets have priced hawkish outlooks for most central banks.
• Real assets: Global Listed Infrastructure (GLI) has been one of the better-performing asset classes so far this year, while real estate investment trusts (REITS) have lost more than 20%. GLI is expensive on several measures, including dividend yields and price-to-earnings ratios. REITS, by contrast, show good value on these measures. REITS stand to benefit if a recession is avoided and post-pandemic normalisation continues. GLI has benefited from energy price gains this year and will be at risk if oil and gas prices decline. Commodities gave up some of their returns over the past three months but are still the best- performing asset class so far this year. Energy and agricultural prices have surged on the Russia-Ukraine conflict. Global recession is a risk for commodities, but one potential upside is a recovery in Chinese demand in 2023 as lockdowns ease and more stimulus measures are adopted.
• The U.S. dollar has made gains this year on Fed hawkishness and safe-haven appeal during the Russia-Ukraine conflict. It could weaken if inflation begins to decline and the Fed pivots to a less hawkish stance in early 2023. The main beneficiaries are likely to be the euro and the yen.