Recession or No Recession. That is the Question

Leo Wealth

Harmen Overdijk, CFA

The May Consumer Price Index (CPI) number of 8.6% clearly shocked the Federal Reserve. Which forced the Fed into action, delivering a supersized 75 bps rate hike at its June meeting. The FOMC now expects to lift rates to as high as 3.8% in 2023, up from its projection of 2.8% in March and 1.6% last December. For the first time in many years, U.S. monetary policy will no longer be unambiguously accommodative.

The high inflation causes more and more social unrest and fear, which in turn increases the odds of a global recession. The moment everyone becomes very negative about the economy, the risk is that it becomes a self-fulling prophecy.

Compared to last month, we think the odds of a recession have increased. However, we still think there is a decent chance we will experience a soft landing or only a mild recession, reflecting strong underlying economic fundamentals.

Naturally, the Federal Reserve does not want a recession. Its forecast sees the unemployment rate rising only modestly from 3.6% at present to 3.9% in 2023 and 4.1% in 2024, bringing it close to the Fed’s full employment estimate of 4%.

The danger is that the unemployment rate increases by more than half a percentage point. Rising unemployment tends to feed on itself. Households react to a weaker labor market by paring back consumption. Businesses react by cutting investment. The resulting decline in aggregate demand leads to higher unemployment and even less spending.

The good news, in this sea of negativity, is that labor markets around the world are still very strong. At the same time, both household and corporate balance sheets are in much better shape than they have been in decades. Other than in China, there are also no major imbalances in property markets like we had in 2007.

A so-called soft landing, which means a slowing economy but without a recession, is possible. Especially because the sort of financial imbalances that have exacerbated recessions in the past are generally absent in the U.S. today. This implies that if a recession does occur, it could be a fairly mild one.

Recession in Europe: When it Rains, it Pours

While the U.S. may manage to avoid a recession, it is more likely that Europe will experience one as it is much more impacted by the Ukraine war through sharply rising natural gas prices. The natural gas shock is like the 1970s oil shock.

The difference is that it is more localized in Europe. While oil can be moved around the world easily, we do not yet have the infrastructure to move large quantities of Liquefied Natural Gas (LNG) around. There are not enough LNG tankers and more importantly the specialized terminals to receive LNG. Most natural gas is transported by pipelines, with the biggest ones between Russia and Europe.

That is why energy prices in Europe are going through the roof while in the U.S. natural gas prices are falling. This was exacerbated by the recent fire in the Freeport LNG terminal in Texas, which handles 16% of U.S. gas exports. The fire was small, and nobody was hurt but the terminal will be out of service for at least three weeks. Freeport is one of seven U.S. LNG export terminals, which receive gas via pipeline and liquify it before loading the super-chilled gas onto tankers. The terminals have helped the U.S. emerge as a major LNG exporter over the past few years. With Europe importing more LNG from the U.S., the blaze had a significant upward impact on the price of LNG in Europe. In the U.S., however, prices fell because there will be more supply for the local market.

To make matters worse for Europe, employees of state-owned Norwegian energy company Equinor have gone on strike, forcing the company to shut gas and oil fields. Equinor owns and operates the largest European gas fields. When it rains, it pours.

Germany, which is one of the biggest natural gas users, has announced it might ration energy and that it will prioritize residential users. This will have an impact on Germany’s industrial production capacity and makes a recession in Europe more likely in the short-term.

Longer-term the picture is more positive for Europe. Europe has committed to invest 210 billion euros over the next five years to achieve energy independence from Russia. Combined with increased defense expenditures, the IMF expects the structural primary budget balance to swing from a surplus of 1.2% of GDP in 2014-19 to a deficit of 1.2% of GDP in 2022-27.

This fiscal spending will support the euro area economy. However, it will come at the cost of higher government debt levels. For countries such as Germany, this is not a problem, but for others such as Italy, it is a bittersweet outcome.

The Chinese Economy

The Chinese economy continues to suffer Covid lockdowns, lower demand for manufactured goods, and a soft property market. Further downturns in the property sector represent the biggest long-term threat. Chinese real estate prices are amongst the highest anywhere. The Chinese economy is very much a managed economy, but eventually the Chinese property market could face the same fate that befell Japan 30 years ago. As was the case in Japan starting in the 1990s, China’s working-age population is now shrinking, which will erode the demand for housing over the coming years.

Still, a hard landing for China’s property market is unlikely in the short-term. The Chinese government retains control over the domestic banking system. A broad-based credit squeeze is not in the cards. Nor is a significant decline in residential investment. If anything, the authorities want to expand the supply of housing to make it more accessible and affordable to poorer households. 

Then there is the likelihood of more fiscal stimulus. With the Twentieth Party Congress later this year and the population worn out by lockdowns, the political incentive to shower the economy with cash and loosen the reins on regulation will intensify. 

Indeed, we have already seen the first signs of recovery with China’s service sector expanding after three months of contraction. The China Caixin non-manufacturing PMI surged to 54.5 in June from 41.4 in May, handily exceeding expectations of 49.6, and pointing to the strongest increase in service sector activity since July 2021. Moreover, new orders returned to growth. Chinese service providers are reporting lower inflationary pressures and their confidence in the 12-month outlook for business activity remains strong. This bodes well for Chinese stocks.

We Still Believe That Inflation Will Moderate

We should realize that some of the inflation associated with demand-driven factors has also been strongly influenced by pandemic-related dislocations. For instance, the composition of spending shifted from services to goods during the pandemic. One might think that the composition of spending should be irrelevant for inflation, as only the aggregate level of spending should matter. In practice, however, that is not the case. 

An example to illustrate this is that firms that sold fitness equipment during the pandemic had no qualms about raising prices. In contrast, gyms didn’t cut prices, figuring that lower membership fees would do little to drive new business through the door. Now that the economy is open again, we see big price cuts in gym equipment, but prices of gym memberships are again not moving much.

This is an important phenomenon as we argued before that durable goods inflation is never structural. As spending continues to shift back to services, goods inflation could decline much more than services inflation rises. This could push down overall inflation, even if one adjusts for the higher weight of services in price indices. A recession scare will also help to bring headline inflation numbers down.

Rent inflation is another category within the CPI that was distorted by the pandemic. Aided by lower mortgage rates and working from home led to a sharp increase in the demand for bigger and better housing. Home price appreciation has historically been an important driver of rent inflation. As the housing market cools, rent inflation will recede.

Importantly, many commodity prices have also fallen sharply recently. Copper prices have dropped to a 16-month low. Wheat prices are down 36% from their high. The price of lumber has fallen 45% since the start of the year.

Energy prices have remained high, but are also starting to trend down, thereby relieving inflation pressure. Already, U.S. retail gas prices are on average down 5% from the peak in June. As the old saying goes, “the cure for high oil prices is high oil prices.” High oil prices tend to lead to more investment in the energy sector, while at the same time suppressing oil demand, both in the near term, as people drive less, as well as in the long run, as more people elect to purchase an electric car.

Another catalyst could be President Biden’s upcoming visit to the Middle East. The expectations are that he will come away empty-handed. That may be too pessimistic. The Saudis do not want the U.S. to lift the embargo on Iranian oil, but if Biden threatens to do so, they may offer to raise production instead. From the Saudis’ point of view, it is preferable that they sell more oil rather than the Iranians.

Equity Markets 

Whether we experience a soft-landing or a recession, it is likely that global earnings estimates will come down, but not as rapidly as most investors expect. And this is key as valuations have come down a lot this year, already discounting a lot of bad news, including the increased odds of a recession. The S&P 500 is currently down 21% from its peak in early January. International stocks have fallen by a similar amount.

If one had been told at the start of the year that the MSCI All-Country World Index would be down 21%, one probably would have concluded that earnings estimates had fallen substantially. In fact, they have not: while 2022 EPS estimates for emerging markets are down slightly, they are up for the U.S. and Europe.

If the global economy falls into recession, forward earnings estimates would surely decline. In contrast, if a recession is avoided, earnings estimates are likely to remain flat, and could even rise if supply-side cost pressures decrease. At this point, even a modest decline in earnings would probably be seen as a positive surprise.

Since the May CPI release prompted the Fed’s mega rate hike in June, the S&P 500 fell by an additional 5%, concluding its worst first half since 1970. The big selloff implies that much of the bad news is already priced in. And even though several factors point to a significant economic slowdown, a recession is not a foregone conclusion. Positive surprises on the inflation or consumption front could trigger a market rebound. In fact, declining commodity prices, easing supplier delivery components, and falling shipping costs all suggest that supply-side inflationary pressures are receding. Similarly, shifting spending patterns from goods to services will lower demand-side pressures on goods prices. Meanwhile, the $2.2 trillion in excess savings accumulated since the start of the pandemic provides a buffer for American consumers to continue spending.

There is also the view that U.S. profit margins are high and will have to come down. This could happen; however, we think that this may take a lot longer to happen than the market anticipates.

Growth Stocks Are No Longer Expensive 

The year-to-date equity selloff has been particularly painful for Growth stocks. The S&P 500 Growth index’s 30% drawdown dwarfs the Value index’s 15% decline. The sharp increase in bond yields has weighed more heavily on the performance of growth stocks, which have a longer duration and are therefore more sensitive to interest rate dynamics. The aggressive selloff has brought relative valuations for growth versus value stocks closer to neutral territory from extremely overvalued. Similarly, technical indicators suggest that growth is now deeply oversold.

While these developments are positive signals for growth stocks, the macroeconomic outlook justifies a more cautious approach over the near-term. The higher-than-expected CPI release for May underscores the possibility of further upside surprises from inflation. The Fed has communicated that “a series of declining monthly inflation readings” is needed to provide compelling evidence that inflationary pressures are abating and justify easing to a 25bp per meeting pace of rate hikes. Thus, until inflation has clearly peaked, the central bank is likely to continue lifting tightening monetary policy aggressively.

We ultimately expect inflationary pressures to moderate later this year and bond markets already anticipate a slowing in the aggressive pace of rate hikes. These dynamics reduce the extent of further upside pressure on bond yields, and this will be positive for growth stocks. Profitable growth stocks are now trading at very attractive valuations. Last month we turned positive on the NASDAQ, and although it was a bit early, the NASDAQ did not do worse than the MSCI World Index in June.

We also turned positive on Chinese growth stocks last month and not only did they outperform, they delivered positive returns in June. We think they can continue to outperform. The Chinese economy is not going to collapse, more fiscal stimulus is likely on its way and Chinese stocks have discounted a lot of bad news. Given current valuations, we recently increased the allocation to Chinese tech companies in our global and Asian portfolios.

Fixed Income

While global bond yields still have scope to rise over the long term, they are unlikely to rise much over the next 12 months as inflation declines. We now think that the 10-year Treasury yield will finish the year close to the current 3% level, with risks tilted to the downside in the event of a recession. In other words, we don’t expect to see a large movement in bond yields over the next 12 months, which justifies a neutral stance in fixed-income portfolios as yield income is now a lot higher than a year ago.

We turned more positive on high yield credit and remain very positive on private credit. Credit spreads have risen, discounting a much higher default rate but as we are expecting at most a mild recession, and corporate balance sheets are in decent shape, private and high yield credit seems attractive to us at ~8% yields. Many high yield issuers have issued longer-dated bonds to take advantage of lower rates, but we prefer short-dated exposure given long-term uncertainty.  For this reason, we think private credit is particularly attractive for those able to make allocations right now – not only is it ultra-short duration, but collateral levels remain robust. In the same vein, given overall higher yields corporate debt will likely outperform government bonds.

The Mighty U.S. Dollar

The U.S. dollar, which is now almost as overvalued as it was 1985, is set to weaken eventually. The trade weighted dollar index (DXY) has strengthened 9.6% since the start of the year and is now up 17.5% since May 2021. Relative to its Purchasing Power Parity (PPP) fair value, the dollar is 29% overvalued. This level of overvaluation now exceeds that reached in 2000 and is close to what was observed in 1985. Over long-term horizon of 5-to-10 years, valuation is an important driver of currency returns. The deviation from PPP has been a reliable indicator of long-term movements in the EUR/USD exchange rate.

In the short-term, however, technical and cyclical factors matter more. So, it is possible we will see parity between the dollar and the Euro before we see a turnaround. Interest rate differentials have moved significantly in the dollar’s favor over the past 12 months. This tailwind is starting to fade and may even reverse direction over the next 12 months as falling U.S. inflation allows the Fed to breathe a sigh of relief.

Buy the Yen

The Japanese yen could be the surprise winner during the remainder of the year. The yen is cheap. Very cheap. It is trading at the biggest discount to PPP in its history. Sentiment towards the yen is extremely bearish. The Japanese economy is recovering from the pandemic disruption, while inflation is rising. The reason for the Yen weakness is the dovishness and domestic market intervention of the Bank of Japan, but that could change.

In light of the success of our Equity Income portfolios (which remain positive year-to-date), we will be launching a Japan Equity Income portfolio with a gross dividend yield of ~4%. Japanese stocks are not expensive, and the upside potential of the yen makes this portfolio extra attractive.

Portfolio Actions

Our views on markets remain constructive and we are comfortable with our current portfolio allocation. Last month we slightly increased risk exposure by adding NASDAQ, China tech and clean energy. In hindsight, it was a bit early to turn positive, but we believe a neutral portfolio allocation with tilt to growth stock stocks makes sense on a 12-month horizon.

In fixed income, we moved closer to neutral duration but continue to favor short-dated credit exposure.


This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. 

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies

The U.S. Dollar Index (USDX, DXY, DX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies.  The Index goes up when the U.S. dollar gains “strength” (value) when compared to other currencies.  The index is designed, maintained, and published by ICE (Intercontinental Exchange, Inc.), with the name “U.S. Dollar Index” a registered trademark.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

S&P 500 Growth Index is a market-capitalization-weighted index developed by Standard and Poor’s in conjunction with Citigroup. It consists of stocks within the S&P 500 Index that exhibit strong growth characteristics. The S&P 500/Citigroup Growth Index is the outcome of a numerical ranking system based on three growth factors and four value factors to determine the constituents and their weightings.

The MSCI ACWI Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes.

The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures.

Purchasing managers’ indexes (PMI) are economic indicators derived from monthly surveys of private sector companies.  The three principal producers of PMIs are the Institute for Supply Management (ISM), which originated the manufacturing and non-manufacturing metrics produced for the United States, the Singapore Institute of Purchasing and Materials Management (SIPMM), which produces the Singapore PMI, and the Markit Group, which produces metrics based on ISM’s work for over 30 countries worldwide. 

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

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