Recession or not, growth is slowing: Our macro team’s view

Recession or not, growth is slowing: Our macro team’s view

10 minute read

August 2022

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Our base case calls for a shallow recession as inflation peaks and central bank policies take hold. Here’s how we’re positioned across key strategies.

KEY TAKEAWAYS

 

  • Markets and the economy have arrived at a pivot point – growth is decelerating as actions by central banks to rein in inflation take hold.
  • Our base case is that we are entering what can be deemed an average recession – shallow and moderate in length – while inflation has either peaked or is peaking.
  • Volatility is likely to remain elevated, and our portfolio managers generally are focused on both positioning defensively and as well as the opportunities created in the dislocations.

When GDP numbers were released for the second quarter, they confirmed what we have known for some time. Economic growth is slowing.

Much of the focus has been on the semantics of whether we are in a recession or not, but that’s not our primary focus. Regardless of the label, it’s clear growth is decelerating, though it is against a backdrop of jobs numbers that remain resilient.

Most recently, consumer and corporate spending, which have to date been viewed as economic strengths, have slowed too. Real incomes are also falling as pandemic stimulus wears off (see Exhibit 1). These are significant shifts.

EXHIBIT 1

Falling real income as pandemic stimulus wears off U.S. real disposable income per capita

US real disposable income per capita

We believe we have arrived at a pivot point. Markets rapidly moved from wondering if and how the U.S. Federal Reserve will respond to rein inflation in to questioning whether the economy can handle the Fed’s response.

Our base case is that we are entering what can be deemed an average recession, as measured against previous recessionary periods. An “average” recession would imply a shallow drop—a decrease of approximately 2–3% in real GDP—and a duration of about 12 months.

That’s a base case, and there is much that can vary from here.

Our clients, according to a recent survey we conducted, are anticipating a mild recession. While 89% respondents to our survey1 believe that the U.S. will enter a recession, 68% expect it to be mild, while 21% anticipate an average recession. No respondents indicated they felt it would be severe.

We think a softer landing for markets and the economy can be achieved if global supply chains recover, if commodity prices moderate (especially if the war in Ukraine deescalates), and if wage growth moderates if labor force participation rises. On the other hand, if high inflation remains entrenched— and especially if wage prices begin to spiral—central banks will likely push markets to a harder landing through demand moderation (in the form of higher rates).

Volatility is likely to remain elevated in the months ahead as markets discern whether we’re in for a hard or soft landing. In general, our portfolio managers are focused on positioning defensively as well as the capturing opportunities likely created in the dislocations and more recent pullbacks in many asset classes. We are experienced managers and have seen economic slowdowns and bear markets before.

With that experience as a guide, there are a number of signposts we are watching to determine the path ahead (see chart).

Volatility is likely to remain elevated in the months ahead as markets discern whether we’re in for a hard or soft landing.

Recessionary signposts: What we’re watching and why

Recessionary signposts- What we_re watching and why

We anticipate that high commodity prices, tight labor markets, high housing costs, and shortages of goods and materials across industrial sectors will keep inflation elevated in the months ahead. Yet, it appears that inflation may have already peaked at very high levels. July’s Consumer Price Index print is being interpreted as favorable by markets, though we think it’s notable that the breadth of inflation is actually still rising. . The Fed’s moves, which are part of the fastest global central bank pivot ever (see Exhibit 2), appear to be having the intended effect, though we think it is too soon for the Fed to declare victory.

EXHIBIT 2
Fastest global central bank pivot ever

Net number of global central bank rate hikes

Net number of global central bank rate hikes

Inflation will likely drop as the Fed’s aggressive efforts to dampen demand take hold and supply constraints slowly ease. However, the peaking process will likely be longer and more arduous than anticipated, as the underlying drivers of inflation have transitioned from acute price pressures in a few areas, such as used cars or airfares, to a broader-based basket of domestic and international goods and services.

It is our view that slowing demand and tightening policy will result in significantly lower inflation rates by the end of 2023. A key question is whether inflation will fall by enough to satisfy the Fed. On that front, the key question is what the Fed will be willing to accept.

We do believe inflation will remain higher than it was during the pre-pandemic, post-Global-Financial-Crisis recovery, stemming from a confluence of supply- and demand-side considerations.

On supply: the Russian invasion of Ukraine, China’s relatively punitive policy toward zero-Covid containment, and secular transition from fossil fuels to renewable energy sources all have potential to curtail the immediate and available supply of goods and services globally.

On demand: the introduction of means-based income-replacement programs during the Covid-19 pandemic represented a potential turning point in fiscal policy activism that may have popular support in the years ahead.

Again, what is important to note is that the efforts to rein in inflation have pushed the U.S. economy into a slowing period. Our base case is that slowing growth and still-high inflation mean we will be in a stagflationary environment for some time, and that has significant implications for portfolio construction.

Importantly, real assets typically outperform stocks and bonds during periods of lower-than-expected growth and higher-than-expected inflation, demonstrated both historically and in performance in the first half of this year. As forces behind inflation persist—high commodity prices, tight labor markets, high housing costs—the odds of remaining in a favorable regime rise.

Key questions remain for our portfolio managers: How much of a hard landing scenario is priced into markets? And how should this factor into positioning, given the macro environment as well as valuations—many of which have been driven down significantly?

Our base case is that slowing growth and still-high inflation mean we will be in a stagflationary environment for some time.

Here are our key outlooks:

Here are our key outlooks

FURTHER READING

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