Is the U.S. more vulnerable to a recession?
On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Investment Strategy Analyst BeiChen Lin discussed key takeaways from recent meetings by the U.S. Federal Reserve (Fed) and the European Central Bank (ECB). They also assessed the risks of a U.S. recession.
Fed hikes rates by 0.75% in aggressive bid to tame inflation
Lin noted that the week of 13 June proved especially volatile for U.S. markets, with further selling on Wall Street the day after the Fed announced a 75-basis-point (bps) rate hikethe steepest increase since 1994. Characterising the hike as a significant move, Ristuben said that markets are still digesting the central bank’s forward guidance on rates, inflation and growth.
"By opting for a 0.75% increase in the overnight rate, instead of the 0.50% hike that was originally planned, the Fed is sending a signal to markets that it’s really going after inflation hard," he stated, explaining that May’s unexpectedly high consumer price index (CPI) reading was the impetus for the jumbo-sized rate increase. The move reiterates the tone the central bank has been trying to set all year, Ristuben added, which is that inflation is public enemy number one.
The Fed now projects that its benchmark rate will rise to around 3.375% at the end of 2022, he said, and it also sees restrictive monetary policy to be between 3.0% and 3.5%. "Essentially, what the central bank is saying is that it thinks it can raise rates to a level that will actually be restrictive to the U.S. economy by the end of this year," Ristuben remarked. This guidance, he said, has led markets to really start processing recession risks.
Eurozone bond-market fragmentation risks lead to emergency meeting
Broadening the discussion to other major central banks, Ristuben said that besides the U.S., the Bank of Canada, the Reserve Bank of Australia and the Bank of England are all projected to raise interest rates 10 times or more this year (when measured in 25-bps increments). He noted that the Bank of England instituted its fifth consecutive rate hike on 16 June, lifting the base rate to 1.25%. "It’s important to understand that there’s a lot of company in this monetary-tightening cycle, as most major central banks are now lifting or planning to lift borrowing costs," Ristuben remarked.
Focusing in on the ECB, which is likely to raise rates for the first time in 11 years next month, he noted that the bank held an emergency policy meeting on 15 June to address bond-market fragmentation risks in the eurozone. Fragmentation occurs when credit spreads between member states of the bloc widen, Ristuben said, explaining that this was a large problem in the eurozone a decade earlier during the sovereign debt crisis, when government bond yields in southern member-states, such as Italy, Portugal, Spain and Greece, spiked in dramatic fashion. "As a result, the ECB pays very close attention to the difference between the yield on the 10-year German bond and the yield on the 10-year Italian bond," he said. After widening considerably in the past week, the ECB effectively put in place, at the meeting, a mechanism to buy Italian, Portuguese, Spanish and Greek bonds in order to keep the spread lower, Ristuben explained.
"Ultimately, the situation in the eurozone shows that financial stress is beginning to crop up in other parts of the world not just in the U.S.," he said.
Is a mild recession already priced into U.S. stocks?
Turning to recession risks, Lin noted that the topic has become top-of-mind for investors across the globe. Ristuben said it’s a very valid concern, given the aggressiveness of global central banks in raising rates. The U.S. in particular is probably the most vulnerable to a recession, he noted, as it’s further along in the economic cycle than other developed markets and has a central bank that’s among the most active in tackling inflation. The Fed is trying to rein in inflation by softening demand, and that’s done by lowering economic growth, Ristuben remarked, noting that the central bank downgraded its projection for 2022 GDP (gross domestic product) growth to 1.7% at the June meeting. "What the Fed is really saying today is that it’s willing to sacrifice the U.S. economy by letting it tip into a recession in order to establish control over inflation," he stated.
As markets process all of this, it’s helpful to think about 2022’s selloff in context, Ristuben said. The S&P 500® Index is well into bear-market territory, he noted, with the U.S. equity benchmark down approximately 24% from its 3 January high. Compare that to the average market drop in a U.S. recession of about 35%, he said, and it’s likely that a mild recession is already built into market expectations. The question for investors then turns to how much further markets have to fall before bottoming out, Ristuben noted.
He added that assuming a recession doesn’t happen relatively soon Ristuben believes the most likely start of one isn’t until mid-2023 there’s a chance of a bear-market rally. He cautioned against making changes in this type of environment, noting that he’s stressing to clients the importance of sticking to their strategic asset allocation and portfolio weightings.
"You don’t want to expose yourself to the behavioural mistakes of chasing a bear-market rally and buying in toward the end, only to see it roll over again" Ristuben explained. "There’s a lot of volatility in these types of markets, and no one knows what’s going to happen. And when you don’t know what’s going to happen, I believe it’s more important than ever to stay disciplined and stick to your investing plan."
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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.