Is a recession really on the horizon?

LGT Crestone

LGT Crestone

Fears of a sharp slowdown in global growth have continued to intensify over recent months. Inflation has proven to be stickier than most expected, interest rates have risen more rapidly, the war in Ukraine has persisted, and there have been ongoing challenges in the property sector in China. Consequently, market volatility has risen and the narrative around whether we can expect to see a recession has shifted. Our panellists discussed whether we are likely to see a recession, whether inflation is peaking, and if banks can avoid overtightening.

This discussion is an excerpt from LGT Crestone’s most recent investment forum, you can access the full report attached below in this wire. 

We are in the hands of central banks

Alex Joiner, Chief Economist at IFM Investors, reflected on where we were 12 to 18 months ago, noting that investors were able to consider a range of scenarios, which included an “upside” case. Economies were emerging from the pandemic relatively unscathed and there had been the potential for some upside due to monetary and fiscal stimulus measures. Now, investors are faced with a range of “downside” scenarios, which include recession (such as in the UK and Europe) and just avoiding recession (such as in the US).

Anthony Kirkham, Head of Investment Management at Western Asset Management, believes we are now in the hands of central banks. The US Federal Reserve (Fed) is determined to squash inflation. And while he feels this approach makes sense, he acknowledged that “if you’re going at speed, you’re more likely to crash”.

Amy Xie-Patrick, Head of Income Strategies at Pendal Group, agrees that the Fed is determined to prioritise the fight with inflation. She highlighted the economic relationship between high inflation and high volatility in markets, and that market volatility leads to bad economic outcomes. She feels the Fed may think that if it does not control inflation today, it will create a much bigger problem for itself further down the track. She also discussed how fiscal policy in some countries was adding fuel to the fire.

“Perhaps if there was a danger of destabilising the financial system, the Fed might slow the rate of interest rate hikes. But, at the moment, it can’t afford to let inflation take equal place to growth.”

Scott Haslem, Chief Investment Officer at LGT Crestone, commented on the mixed reaction function of central banks. He explained that on the Fed’s part, its commentary has remained consistent in terms of needing to keep tightening monetary policy until inflation is at 2%. However, this is in contrast to 20 years of monetary theory, which cautioned against ignoring the long and variable lags of monetary policy.

Joiner added that the Fed’s mindset is that short-term economic pain is better than long-term, persistent inflation. The Reserve Bank of Australia (RBA), however, is taking a more pragmatic approach, assessing the impact of interest rate hikes on Australian households before raising rates too quickly.

Is inflation peaking?

Katie Petering, Head of Product Strategy at BlackRock Australia, explained that inflationary pressures have been driven by production constraints, exacerbated since the pandemic. Blackrock is currently watching the labour force participation rate, and has not yet seen any signs that supply-side issues in the labour market are easing. BlackRock believes central banks are set to overtighten policy in the near term, causing economic damage. It believes that high inflation will be persistent and central banks will be forced to live with inflation as they see the effect of rate hikes on growth and jobs. Although Blackrock feels that inflation will drift lower from here, Petering explained that central banks will need to see a 2% drop in output to get inflation back to target. This equates to roughly 2 million Americans being out of work.

Xie-Patrick explained that the US is currently experiencing a wage price spiral. The labour market is still very tight, and some of President Trump’s immigration policies had contributed to this. However, she commented on the recent JOLTS (Job Openings and Labor Turnover Survey) print, which showed a significant fall in vacancies, but noted there is a time lag with this data.

“Those vacancies are probably bloated compared to what the true vacancies are. Companies are already likely taking those job ads down.”

Mick Dillon, Portfolio Manager at Brown Advisory, believes that inflation is being driven by supply-side factors, and that the real issue is “unexpected” inflation. While emerging markets have planned for high levels of inflation, developed markets have not.

Dillon explained that a key driver of inflation is the labour market, and that there had already been some tightening in the US labour market before the pandemic, with corporates raising wages to attract staff. He feels the labour market will be the key driver if the UK and Europe fall into recession.

“There just aren’t enough people to employ when you’re under 6% unemployment in Europe and under 3% in the UK.”

According to Joiner, job market participation is a key issue. Although it has been fairly consistent in Australia, in other countries fiscal policymakers could be taking pressure off central banks by encouraging participation. As an example, in the US there is a 0.9% gap between where we are now and where we were in 2019.

With inflation likely to remain above target for an extended period, Joiner believes that it will be key for investors to invest in strategies that can cope with this scenario.

Which economies will fare better?

Haslem explained that most consumers globally have excess cash on their balance sheets. He commented that this economic cycle is unusual as normally, once interest rates reach neutral, consumers are already geared and the impact of rate hikes is reasonably quick. Now, he explained, we have a situation where consumers have excess cash, and there is a great amount of uncertainty around how consumers will behave as interest rates rise.

Kirkham believes the US and Australia are likely to fare better than most other economies, while Petering sees the US at risk of tipping into a recession. However, she sees this as unlikely to happen until next year, and if the US does enter recession, it is unlikely to be a deep recession.

Dillon explained that in the US there are a high number of people on 20 to 30-year fixed-rate mortgages. With few people refinancing at current interest rates, the rise in interest rates do not impact discretionary spending as much as seen in the UK or Australia, where mortgages are typically variable rate.

Xie-Patrick added that in the US, although a strong US dollar is beginning to have an impact on households, it does not appear to have impacted corporates yet.

“Corporates have now finally emerged from repairing their balance sheets following the GFC, and credit growth is expanding at a double-digit rate after a decade of low single digits.”

Xie-Patrick feels Europe is the most obvious pain point due to the energy crisis, war in Ukraine, and its fortunes tied to China’s economy. Petering agreed that the UK and Europe are at risk of falling into recession this year.

Is Australia a relative outperformer?

Haslem commented on the thesis that Australia could do quite well in this environment as it is a net energy exporter. Rising commodity prices will generally benefit Australia, and in the near term, Australian growth may outperform other regions.

Joiner feels that Australia might do well in a relative sense— largely as a result of good luck rather than good management. However, he acknowledges that the RBA’s recent decision to hike interest rates by 25 basis points (bps) rather than 50bps could be the first sign of good management. Joiner believes that Australian consumers are at a crossroads. While they have excess cash on their balance sheets, they are uncertain about what they should do with it.

“Deposit rates are becoming competitive—but as a mortgage holder, the best place to put your money is in a mortgage offset account.”

He explained that Australia’s terms of trade and population growth should work in its favour. The terms of trade provide the Government with a $50 billion surplus in the budget. While that will likely fall, it is probably some distance away. The Federal Budget has forecast around 1.4% population growth, which is significantly higher than other developed economies.

“It’s harder to have a recession in Australia because we have a significant margin to start with. The RBA has forecast 1.7% growth to 2024, implying 0.4% per capita GDP growth. Holistically, real GDP looks like it will be robust because of that reason.”

What is the growth outlook for China?

Xie-Patrick explained that, during the pandemic, policymakers in China attempted to stimulate the economy, which subsequently made its way into the property sector. Now, the property sector is experiencing one of its worst downturns in history and the Government appears resolute on “keeping its foot on the brake”, even if that leads to corporate defaults. Xie-Patrick explained that, in some cases, large companies have failed—and some of these have had strong ties to the state government.

Xie-Patrick believes that if the property sector weakens for an extended period, then the future growth rate for China will likely be a lot lower than anyone expected—and possibly more similar to that of a developed economy’s growth rate.

With growth in China now entering a very mature stage of the development cycle, this may have a negative impact on the Australian economy. And while the National People’s Congress may see a gradual relaxation of the zero-COVID-19 policy, this is likely to provide more of a boost to China than Australia. This means that Australia will need to look to other sources of structural growth, relying less on its commodity exports.

What does the stronger US dollar mean for investors?

Petering highlighted that the stronger US dollar has impacted most assets, and explained that BlackRock has moved overweight the US dollar to create a buffer for portfolios. Xie-Patrick added that a stronger US dollar has created headwinds for emerging market economies, who have been forced to start their hiking cycle earlier than desired.

“For a while, emerging economies had a huge real rate advantage. Brazil has had in the region of 13% worth of hikes and is still not in a recession. With the Fed now hiking at a pace not seen in modern history, it’s forcing emerging market central banks’ hand.”

The LGT Crestone view: We continue to believe a broad-based global recession can be avoided—but greater evidence is needed that actual inflation is on a downward path and ‘demand destruction’ is sufficient to ensure future inflation stays on that path. LGT Crestone is tactically overweight domestic equities. 

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