Two words have battled for supremacy in investors’ minds over the course of the year: ‘Recession’ and ‘inflation’. The higher US inflation climbs, the greater the realisation that a recession may be necessary to bring the rate of price increases back down to the Federal Reserve’s target of 2% for core personal consumption expenditures (PCE).
Not surprisingly, Google searches for the term ‘recession’ peaked immediately after the Fed (abruptly) decided to raise policy rates by 75bp instead of 50bp as expected at its latest policy meeting (see Exhibit 1).
News articles increasingly cite surveys of investors, economists and CEOs in which a majority foresee a recession sometime in 2023. Many point to the bear market in US equities as the most obvious sign of an impending downturn.
If one wished to do so, however, it is also easy to point to expectations that a recession is not likely.
While Fed Chair Jerome Powell has acknowledged the recession risk, the Fed’s own projections of GDP growth in the years ahead point to the economy growing a steady pace of 1.7%-1.9% over the next few years, even as inflation reverts to the target level (a quintessential ‘soft landing’).
Consensus economist estimates according to Bloomberg call for quarterly GDP growth never dropping to below 1.6% (on an annualised basis) between now and the end of 2023 (see Exhibit 2).
Hmm, so what is the word on the markets?
From bond market perspective, only a low percentage of the yield curve is inverted. It is far less than the level that normally indicates that a recession lurking around the corner. While 10-year Treasury yields have retraced from the 3.5% reached in mid-June, they remain above 3%.
One can argue that even the equity market is not pricing in a recession. While it is true that the market has declined sharply this year (troughing at -23% at the low in mid-June), this has occurred while earnings expectations have actually risen. In a recession, earnings typically decline by around 20%. This then results in a commensurate fall in the equity index level.
Admittedly, the gains in earnings have been driven by commodity sector companies, but even excluding commodities, the negative revisions have been small (at only about 2%). For this year and next, earnings growth is still expected to average around 8% (both including and excluding commodity sectors).
Recession or less inflation?
If the recession fears are realised, however, the optimism currently apparent in equity markets is unlikely to last.
To reach the Fed’s inflation target, PCE inflation needs to fall by 6.5 percentage points from the current 8.5% level. Markets currently expect the fed funds rate to rise by 3.5%. Historically, moves of this size have corresponded with declines in the S&P 500 equity index of around 30%.
The more benign scenario is that the Fed does not need to depress demand by raising interest rates to such a significant degree to bring inflation down. The inflationary pressures could finally begin to wane, but that would require an easing of geopolitical tensions over Ukraine to allow oil and gas prices to fall, alongside a sustained reopening of the Chinese economy to reduce supply chain bottlenecks.
Everything will depend on the path of inflation in the months ahead.