Recession Odds are Falling
Mark Luschini, Chief Investment Strategist
The improvement in data releases over the past several months has reduced the odds that the U.S. economy will enter a recession in 2023. Certainly, there remains a non-trivial possibility one occurs in the third or fourth quarter of this year, but increasingly the odds tilt toward 2024.
A Question of Timing
Improving real-wage growth (wages adjusted for inflation) and a strong labor market have conspired to boost the outlook from the consensus held as recent as late last year. Still, that will likely only serve to heighten the Federal Reserve’s resolve to thwart the demand that is likely to keep inflation at levels above its long-range target. In turn, the restrictive monetary conditions will firm even more, slowing the economy and leading to a mild contraction.
Therefore, it is not a question of the risk of a recession but rather the timeliness of one. The result of the shifting odds of a recession beginning this year or next have not changed our view that investors should remain balanced by way of portfolio positioning. This means staying invested to realize upside should the recession be slow to emerge or be averted completely while being cautious in the event recession risks creep higher in the next few quarters.
The surge in employment and release of surprisingly strong monthly retail sales figures have underpinned the rationale that consumer spending could remain stout. Strong hiring patterns across certain industries—leisure/hospitality and health care—fueled the recovery in employment sectors that account for a large swath of the vacancies employers seek to fill and there is still room for more.
Additionally, overall business activity has re-accelerated, as confirmed by surveys from the manufacturing and services sectors. Even the beleaguered housing market shows some signs of having passed the point of maximum weakness. Homebuilder sentiment has improved and other news on general housing-related activities, such as new and existing home sales, housing starts and building permits, although mixed, are no longer declining in unison.
Month-over-month data can be volatile; it might be wise for investors not to extrapolate too much from the recent bout of good news. However, what we do know from history is when the Federal Reserve has raised interest rates to a level considered to be tight, which may have been reached at the end of last year as some believe, a recession occurs within 12 months on average. Since the level of what serves as the dividing line between loose and tight monetary settings is somewhat fluid and known only with a lag, the recession-dating process is more an art than science, making the second half of this year to early next year the likely forecast window.
Despite the recent pickup in economic data, we continue to suggest a conservative investment stance is the most prudent course to pursue; after all, the two-way risk we spoke of in the Outlook 2023 report is still ripe.
Upside exists if disinflation continues along the path we’ve seen recently because the Federal Reserve will not have to throttle the economy by tightening more than by what market participants have already discounted. That should help to support equity prices, as investors can leverage that “certainty” by reducing the risk premium applied to risk assets. Conversely, further downside is possible if inflation fails to materially subside and monetary authorities increase rates above market expectations, to a point where the economy falters, corporate profits are undermined, and share prices fall.
Investing for the Long Term
Investors may avoid succumbing to cognitive biases by budgeting for the risk of either outcome, while maintaining a commitment to equities for the long term.
ECB And BOJ Hold Key For USD
Guy LeBas, Chief Fixed Income Strategist
There is no such thing as a U.S. bond market. Although U.S.-dollar-denominated bonds comprise the plurality of the world’s roughly $120 trillion in bonds at about $50 trillion, they are still less than half of the total. More significantly, changes in regulatory policy during the past decade have meant bonds of different currencies are actually fungible for more market participants. In effect, bond markets have become much more integrated across borders and moves in interest rates are a matter of aggregating trends across countries.
Basel III is a complex set of banking regulations that regulators in every major jurisdiction promised to follow. Solvency II is a similar set of insurance regulations which all insurers that do business in Europe (functionally all major insurers) must also follow. One set of rules in both Basel and Solvency treats all government bonds issued by G10 countries identically for capital purposes. For example, a European bank must hold a portion of its balance sheet in government bonds, but regulations do not distinguish between bonds from different countries. As such, a big global bank will buy, for capital purposes, whatever its balance-sheet managers think is most attractive. This has the effect of collapsing the differences between countries’ bond markets. For our purposes, that means U.S. investors need to pay attention not only to what is happening in the U.S., but also what is happening overseas.
Over the next year, there is a good chance that interest rate policy from the European Central Bank (ECB) in the Eurozone and to a lesser degree the Bank of Japan (BoJ) will tighten, relative to what is priced in, more than interest rate policy from the Federal Reserve.
When U.S. investors talk about interest rate hikes, we generally talk about what the Fed will do. This makes sense, considering that the U.S. bond markets are the largest in the world and the Fed oversees the tradeoff between growth and inflation in the largest single economy. But markets move on the margin, so we have to care about marginal changes. The most likely marginal change in 2023 is not that the Fed will accelerate its interest rate increases (indeed, the opposite is true), but that the ECB and possibly the BoJ will accelerate theirs, at least relative to what is priced into current interest rates. If that is indeed the case, the U.S. dollar should decline relative to those currencies, which, in turn, may make foreign fixed income investing relatively more appealing.
Chart 1: ECB/BoJ Have Potential to Tighten Policy Faster than Markets are Pricing, Creating Downside for US Dollar
Impact on the Dollar
The ECB is fighting an inflation battle similar to the one the Fed fought in early 2022, only with a six-month delay. Recent CPI data from France (6.2%) and Germany (8.7%) point to accelerating year-over-year inflation. Policymakers have raised overnight rates from negative up to 3% so far, but inflation in the EU continues to rise, skewing the risks to further and faster hikes. Meanwhile, the BoJ has a new governor, Kazuo Ueda, who while arguing that inflation will probably fade, reportedly also discussed some “ideas” on how the BoJ can reduce stimulus and possibly raise interest rates over time. Neither the ECB nor the BoJ is likely to raise rates higher than the market-implied Fed peak of 5.40%, but, relative to expectations, both are more likely to exceed than fall short of those expectations, thereby creating upside potential for their respective currencies and downside for the U.S. dollar.
Today, the markets are pricing in 3.5 more 0.25% rate hikes from the Fed over the next year; four more 0.25% rate hikes from the ECB over the next two years; and two initial rate hikes from the BoJ over the next five years. However, with the Fed continuing to slow its pace, it is more likely that the ECB or BoJ will exceed these priced-in expectations. If that does come to pass, the marginal shift will be for foreign rates to move higher than U.S. rates, putting downward pressure on the dollar.
Stuck in the Middle With You
Gregory M. Drahuschak, Market Strategist
Little did the Scottish folk rock/rock band Stealers Wheel realize that 50 years after its most popular song, “Stuck in the Middle with You,” was recorded, it would be a suitable description for the U.S. equity market.
The 2021 rise in the S&P 500 Index came to an abrupt end January 4, 2022. From that point, the equity market fell consistently until reaching the October 13, 2022, low at 3,491.58. The subsequent rally by February 2, 2023, sent the S&P 500 to its recent high at 4,195.44, which set the roughly 4,200 level as the top of a range that has been in place since spring 2022.
Exiting the top of the trading range in the short term could be difficult. The recent earnings report period did not help, as earnings expectations for the S&P 500 this year fell to a new low at $218.68, which suggests negative year-overyear earnings growth.
Inflation Fight Continues
We doubt that the March 22, 2023, Federal Reserve Open Market Committee policy statement is likely to show the Fed wavering from its inflation fight, as higher for longer appears to be the Fed’s policy mantra. Geopolitical conditions show no signs of improvement, and at some point, contentious debate over the debt ceiling could rattle the market. Unlike the TINA acronym (“There is no alternative.”) prevalent when the equity market was running higher and interest rates were extremely low, TINA might appropriately be used to describe the position Congress is in now when debating whether to raise the debt ceiling.
After the typically weak February (only it and September, on average, end lower), seasonal influences historically turn more favorable in March as the month has ended higher in 46 of the previous 73 years for an average 0.98% gain.
Chart 2: 10 Best March Results for the S&P 500
Chart 3: 10 Worst March Results for the S&P 500
During the February market slide, recession prospects dominated many market narratives. As President Harry S. Truman once said: “A recession is when your neighbor loses his job, but a depression is when you lose yours.” Layoff announcements in recent weeks, particularly in the tech sector, have numerous workers in a state of depression. Nonetheless, a U.S. recession overall is far from a certainty. In fact, the Atlanta Fed’s GDPNow’s estimate of first-quarter GDP growth has moved up in recent weeks to 2.8% by the end of February.
Q4 Earnings Wrap-Up
The market, of course, is always influenced by a range of factors, but earnings and how the market capitalizes them are important.
The S&P 500 ended February at an 18 multiple of estimated 2023 earnings. Although this is not an excessively high valuation, it is far from compelling. With earnings-report season for the fourth quarter largely complete, a major change in the S&P 500 earnings estimate at the earliest is not likely until we get to the next report period beginning in April. However, it appears that even then some of the negative influences that weighed on fourth-quarter corporate results will be present in firstquarter results. This suggests that an earnings rebound significant enough to make the market valuation compelling will take more than a few months to develop.
Before that rebound develops, we believe the S&P 500 will be contained within the 3,800-4,200 range.