US recession risk in late 2023 poses a threat to equities and credit

Christopher Joye

Coolabah Capital

In the AFR I write that in December and early January this column repeatedly warned investors to prepare their portfolios for an interest rate shock that would force the value of equities, fixed-rate bonds, credit, crypto and other asset-classes a lot lower. The rationale was that the three hikes priced for the US Federal Reserve in 2022 was massively underdone and would need to recalibrate to a much tougher 6-7 hikes as the Fed came to embrace the idea that it was battling a persistent core inflation problem amplified by a budding wage/price spiral.

There is now good news and bad news on this front. The good news is that the market has more than fully converged to our expectations and is pricing in at least 8 hikes from the Fed this year, which has been a key driver of the substantial losses incurred by global equities, correlated crypto, credit, and fixed-rate bonds.

Indeed, the fixed-rate Aussie Composite Bond Index lost a record 3.75 per cent in March alone, its worst month in 33 years (as interest rates rise, fixed-rate bond prices fall).

The 10-year government bond yield in the US has leapt from 1.3 per cent in December 2021 to 2.6 per cent at the time of writing. Our target for this variable, which is widely regarded as the benchmark for global price of money, has been north of 3.2 per cent, or in excess of the levels reached in 2018 when the Fed last sought to normalise its cash rate back to around 2.5 per cent. And US markets have this week been pricing in a terminal Fed funds rate of 2.6 per cent, which is slightly below the Fed’s current expectation of circa 2.8 per cent.

For equity investors, then, there might appear to be a silver lining: much of the doom-and-gloom apropos discount rates is already priced in. Sure, 10-year yields could easily climb another 60 basis points or more, but there is a case that much of the damage is done. This glass half full perspective was, in fact, why we thought equities and risk would rally through the Fed’s March meeting.

The bad news is that most Fed tightening cycles end in a recession: more precisely, 8 of the last 11 episodes have delivered one. And it is this recession risk that we are focussed on when trying to determine the next asset pricing regime. I keep hearing equity junkies, which include most investors, claim that their “growth” stocks are going to be fine because they are “leveraged to high inflation”. But are they leveraged to a recession? I think not.

The disconnect here is highlighted by Nobel Prize winner Robert Shiller’s cyclically-adjusted price/earnings ratio for the S&P500, which remains at 36 times, more than double its historical average (17 times) and median (16 times). This ebullience is presumably predicated on a combination of extraordinarily strong economic growth combined with the assumption of the low-rates-for-long paradigm. Neither is likely to last.

The buy-the-dip reflex amongst equity junkies has yet to be fully supplanted by the “sell-the-rip” dynamic, although there is a brewing battle between these contrasting views of the world. If and when consensus concludes a US recession is imminent, it could be the final nail in the “zombie” coffin.

Recall zombies are firms that have emerged since the global financial crisis that rely crucially on the availability of cheap money. More precisely, they are companies that do not generate sufficient profits to service the interest repayments on their debt, even with borrowing rates at multi-century lows. In the US, about 656 of the 3000 listed companies in the Russell 3000 index (or 22 per cent) are classified as zombies. That is, more than one-in-five firms.

In the next recession, the zombies are unlikely to be bailed-out by zero cash rates, ultra-cheap public loans, and near-unlimited money printing to allow central banks to bid up the value of all assets. No, this is likely to be the first “market clearing” recession since 1991 when bad firms were truly allowed to fail and superior enterprises rose up in their stead. That is because central banks will be very focussed on crushing inflation, which will require capital and labour to shift from unproductive zombies to much more sustainable alternatives.

We recently published research that harnesses a model of the relationship between expectations for short- and long-term interest rates in the US to estimate the probability of a US recession. Historically speaking, this model has done a good job of picking the last 11 downturns with only a few false positives.

We find that US recession probabilities peak at about 34 per cent in early 2024. While this might sound low, a probability of this magnitude has historically been a strong signal for a recession arriving in late 2023 or early 2024.

Australia is obviously in a very different situation, with much more benign inflation and wage outcomes. So much so, our putative prime minister did not deem it necessary to know what the Reserve Bank of Australia’s cash rate is (that is, 0.1 per cent) nor the level of unemployment (he thought it was 5.4 per cent, much higher than the current 4.0 per cent rate). This naivete is perhaps an artefact of one of the world’s strongest economies. While labour costs are undoubtedly climbing, they will be alleviated in time by an enormous wave of skilled migration. After all, who would not want to live and work in the “wonder down under”!

Our unique exposure to the global commodity price boom, which has been accentuated by supply-chain frictions and the tragic Russia-Ukraine conflict, is evident in rapidly disappearing State budget deficits. In a new report by Adept Economics, former Commonwealth Treasury official Gene Tunny presented updated forecasts for the State budget deficits this financial and next. Adept find that “upcoming State budgets will reveal over $20 billion, and potentially up to $30 billion, wiped off collective deficits for 2021-22 and 2022-23”.

“The improvement in state budget balances is driven by a faster growing economy boosting state tax revenues, elevated commodity prices enhancing royalties (partly due to the war in Ukraine), and delays in infrastructure projects and related spending,” Tunny says.

Adept forecasts these budget improvements despite assuming realistic costs for the recent NSW and Queensland floods, and a downturn in the housing market.

They also believe the State treasuries can do a better job at delivering more realistic forecasts. “While from a budget management perspective it may be good for state governments to be prudent in their forecasts, in recent years they have been arguably too pessimistic,” Tunny says.

“This reflects a more general forecasting challenge amongst economic agencies, including the Commonwealth Treasury and the RBA.”

Tunny explains that excessive pessimism in economic forecasts has real consequences for the states’ cost of capital and taxpayers. “The interest rate spread the states pay on their debt above the Commonwealth yield curve has consistently jumped following excessively negative budget forecasts in 2020-21 and 2021-22, which have thereafter been massively revised down.”

“Following the mid-year budget updates from NSW and Victoria in December 2020, Standard & Poor’s downgraded both states from their prized AAA ratings to AA+ and AA, respectively,” he continues.

“The loss of these AAA ratings increased both states’ cost of capital. Yet both budget updates proved to be far too pessimistic in their deficit forecasts, with the final deficits in FY21 being substantially less than the mid-year projections.”

We approached Adept to produce this work to independently test and evaluate our own internal analysis, which had arrived at similar conclusions. We find that there is a great deal of value to be gained from engaging global experts to render advice across a wide range of fields, including military conflict risks, global geopolitical relations, advanced statistical research, and domestic policy considerations, to both stress-test our own models and liberate new insights. 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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