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How bad could a recession be?

Jovi Ho
Jovi Ho1/12/2023 08:01 PM GMT+08  • 10 min read
How bad could a recession be?
Will inflation start to behave as economic activity slows?
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If inflation starts to behave as economic activity slows down, central banks will stop raising rates and recessions will likely be mild

Will it or won’t it? The most important question in the coming 12 months is “actually quite straightforward”, insists JP Morgan Asset Management: Will inflation start to behave as economic activity slows?

If this happens, central banks will stop raising rates, and recessions, where they occur, will likely be modest. However, if inflation does not start to slow, we are looking at an uglier scenario, says Karen Ward, JP Morgan’s chief market strategist for Europe, the Middle East and Africa.

The asset manager’s 2023 outlook is fronted by a seemingly optimistic message: “Despite remaining above central bank targets, inflation should start to moderate as the economy slows, the labour market weakens, supply chain pressures continue to ease and Europe manages to diversify its energy supply.”

However, JP Morgan’s core scenario still sees developed economies falling into a “mild recession” in 2023.

International Monetary Fund (IMF) chief Kristalina Georgieva says 2023 will be “tougher than the year we leave behind”. “Why? Because the three big economies — the US, EU and China — are all slowing down simultaneously … We expect one third of the world economy to be in recession.”

See also: Southeast Asia's growth to wane but still outperform

In October last year, IMF cut its projection for global economic growth in 2023 to 2.7% from 2.9% in July and 3.8% in January, citing the ongoing Ukraine War, inflationary pressures and the high interest rates imposed by central banks to quell those price pressures.

A new regime of greater macro and market volatility is playing out, says BlackRock Inc. The world’s largest asset manager even goes one step further to point fingers. “Central bankers won’t ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. They are deliberately causing recessions by over-tightening policies to try to rein in inflation. That makes recession foretold.”

BlackRock’s investment experts see central banks eventually backing off from rate hikes as the economic damage becomes reality. “We expect inflation to cool but stay persistently higher than central bank targets of 2%.”

See also: Watch for policy pivot in China, overstretched stocks in India

Over 75% of fund managers think a recession is likely over the next 12 months, according to a Bank of America Global Research survey released in November 2022. This is “roughly on par with peak pessimism” seen during the Global Financial Crisis in 2009 and the Covid-19 pandemic in 2020, says JP Morgan’s Ward.

But the risks of a deep, housing-led recession like 2008 are low, at least in the US. “First, housing construction was relatively subdued for much of the last decade, which means we are unlikely to see a glut of oversupply driving house prices materially lower. Second, those that have recently bought at higher prices were still constrained by the banks’ more stringent loan-to-value and loan-to-income ratios,” writes Ward.

US households have locked in the low rates experienced a couple of years ago, Ward adds. “Only about 5% of US mortgages are on adjustable rates today, compared with over 20% in 2007. In 2020, the 30-year mortgage rate in the US hit just 2.8%, prompting a flurry of refinancing activity.”

As the global economy waits with bated breath, the chalk to BlackRock’s cheese comes from Goldman Sachs. Despite the market tumult, Goldman Sachs believes the US is likely to avoid a recession.

In the past year, US growth has slowed to a below-potential pace of about 1%, notes Goldman Sachs, owing to a diminishing reopening boost, declining real disposable income — driven by fiscal normalisation and high inflation — and aggressive monetary tightening.

Goldman Sachs sees growth remaining at this pace in 2023. “Unlike a year ago, when our forecast for both 2022 and 2023 was below consensus because we expected a negative impact of monetary and especially fiscal tightening, our current 2023 forecast is well above consensus.”

While investors hope to share that optimism, avoiding a recession would not signal an all-clear for risk assets, note UBS Asset Management’s head of multi-asset strategy Evan Brown and head of investment solutions Ryan Primmer.

See also: 2023 for crypto: Deep freeze, recovery or rocket?

“A more resilient economy may also mean central banks need to do more, not less, to get inflation durably back to target. This raises the risks of a harder landing down the road,” say the UBS experts.

But, in our view, it is too early to pre-position for very negative economic outcomes. A longer-lasting late-cycle environment can persist for some time, and investors will have to be flexible and discerning in 2023 given these potential dynamics.

The new 60/40

The year 2022 has been one of the worst years on record for a US 60/40 portfolio, according to UBS Asset Management. As of mid-November, the year-to-date return from a portfolio with a 60% weight in US stocks and a 40% weight in US Treasuries is –15%.

Investors have had virtually nowhere to hide, writes Nicole Goldberger from UBS’s multi-asset team. Total return from global stocks is –21% through the first 10 months of 2022. Global sovereign bonds and credit have also performed poorly, with total returns of –22% and –21% respectively over the same period.

Goldberger argues that while the longer-term outlook may be more positive, continuing uncertainty increases the appeal of diversifying exposures beyond traditional stocks and government bonds.

UBS’s diversified portfolio, for example, consists of 55% global equities, 33% global bonds — including government, securitised, investment-grade and high-yield types — and 12% real assets such as global real estate, US Treasury Inflation-Protected Securities (TIPS) and commodities.

Navigating markets in 2023 will require more frequent portfolio changes, according to BlackRock. “We see two assessments that determine tactical portfolio outcomes: Our assessment of market risk sentiment and our view of the economic damage reflected in market pricing.”

BlackRock is starting the year with its most defensive asset allocation stance, given its pessimism about the prudence of central banks.

“It’s the opposite of past recessions; loose policy is not on the way to help support risk assets, in our view,” says BlackRock’s team, fronted by vice-chairman Philipp Hildebrand and the head of its investment institute Jean Boivin. “That’s why the old playbook of simply ‘buying the dip’ doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.”

From this cautious baseline, BlackRock’s other options are about turning more positive, especially on equities. “We find that earnings expectations don’t yet price in even a mild recession. For that reason, we stay underweight on developed market equities on a tactical horizon for now.”

Across sectors, BlackRock highlights beneficiaries of structural transitions, such as healthcare amid ageing populations. Among cyclical sectors, BlackRock prefers energy and financials. “We see energy sector earnings easing from historically elevated levels yet holding up amid tight energy supply. Higher interest rates bode well for bank profitability. We like healthcare given appealing valuations and likely cashflow resilience during downturns.”

That said, BlackRock’s “strongest conviction” is to remain underweight on nominal long-term government bonds in any scenario.

In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, as the chart shows, meaning they can both go down at the same time.

This is because central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets, they add. “If anything, policy rates may stay higher for longer than the market is expecting.”

In its place, the case for investment-grade credit has brightened, says BlackRock.

We think it can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields. Agency mortgage-backed securities can also play a diversified income role. Short-term government debt also looks attractive at current yields, and we now break out this category into a separate tactical view.

Not all asset managers are singing a bearish tune though. Like Goldman Sachs, Morgan Stanley is defiant in its equities outlook, claiming the economy is “proving too resilient” to collapse.

The economy is proving too resilient, causing the ‘looming collapse’ in earnings to remain elusive for yet another quarter,” says Morgan Stanley’s head of applied equity advisors Andrew Slimmon in a Dec 12, 2022 note.

I expect earnings to drip down slowly, frustrating market bears. With continuing improvements on the inflation front mixed in, you have the ingredients for a strong first quarter.

Slimmon cites outperformance among financials, industrials and materials in October and November 2022 as the buttress of his bullishness. “If the economy were going to collapse in the first quarter of 2023, these economically cyclical groups would not be leading today.”

What about US tech giants, the darlings of many investors’ portfolios the world over? At their peak in 2000, the five largest tech-related stocks comprised just over 20% of the S&P 500, says Slimmon. Those same stocks bottomed five years later, dropping to only 5% of the S&P 500.

At their peak in 2022, the five largest tech stocks comprised roughly 25% of the index. Are they now headed for 5%? Slimmon says: “On one hand, the 30x average valuations of the five largest tech stocks today will never reach the triple-digit valuations of 2000. But what has historically stunted the growth of the mega S&P 500 stocks is the US government’s desire to abate their dominance — and we are now seeing that with increased regulatory scrutiny.”

Slimmon believes slowing growth rates combined with premium valuations will allow the S&P equal-weighted to continue to outperform the S&P 500 cap-weighted. “We are reducing our exposure to these mega-cap stocks for these reasons.”

Europe most exposed

Markets continue to expect central banks — led by the US Federal Reserve — to stop hiking at the first sign of inflation cooling but there is a growing risk that by then it may be too late.
The squeeze on the consumer is already taking place and some parts of the global economy are headed for recession or are already there, according to Fidelity International.

While global equities share volatility, earnings expectations are diverging across different economies, say Fidelity’s heads of equities Marty Dropkin and Ilga Haubelt.

Regionally, Europe looks the most exposed. “Much depends on whether businesses and consumers can make their way through the winter without blackouts that weaken demand and on how the Ukraine conflict develops from here. Tail risks for stock markets remain and a recession seems baked in, as the European Central Bank ploughs ahead with rate rises at a time when households are already suffering from the surge in the cost of living.”

HSBC Global Private Banking analysts say the UK will experience a contraction of 0.5% y-o-y in real GDP this year. This is down from its forecast of 4.4% growth for 2022.

The Eurozone will not fare much better, according to HSBC, with 2023 GDP growth expected to be flat after 3.4% growth in 2022.

The UK equity market could, however, become an attractive hunting ground in 2023, says Fidelity’s Haubelt, after the sharp selloff spurred by the worsening outlook and government missteps. “While the UK market has done better than most this year, partly due to sector composition, with most large-cap earnings derived from outside the UK, it remains relatively cheaply valued with a forward P/E that is around 25% below long-term averages and close to 50% cheaper than the US.”

Compared to the consensus, Fidelity claims to be more positive on Asia-Pacific excluding Japan, with the Asean and Indian economies standing out, building on a robust recovery in 2022.

“Within the region, we are long-term positive on both India and Indonesia, amid robust multi-year growth supported by favourable demographics, including a growing middle-class and rising disposable incomes,” says Dropkin. “On its own, Indonesia is a net energy exporter and is one of a few countries to benefit from increased energy prices, which should persist into 2023.”

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