Airline pilot Sully Sullenberger achieved a miracle landing on the Hudson in 20091. U.S. Federal Reserve (Fed) Chair Jay Powell’s attempt at a soft landing for the U.S. economy may have an even higher degree of difficulty. This pandemic-generated cycle has been unusual in so many ways that a soft landing cannot be ruled out. But the lessons from previous cycles say that sticking to the landing is a challenge. Once the economy starts to slow in response to aggressive tightening, it usually overshoots into recession.
Other developed economies are also under stress from aggressive monetary tightening. Europe appears on the verge of recession and the UK economy continues to stagnate. Japan remains an outlier with accommodative monetary policy and above-trend gross domestic product (GDP) growth. China’s debt and property market problems are intensifying, and the government still seems reluctant to undertake aggressive stimulus measures.
Markets are betting that a soft landing is likely. Industry consensus expectations are for a rebound in corporate earnings next year and interest-rate markets are pricing only modest central bank easing.
We think a mild recession before the end of 2024 is the most likely outcome, but the complexities caused by the pandemic make forecasting difficult. The lockdowns and reopening disrupted supply chains caused inflation to surge and sent the cycles for goods and services out of sync. Goods demand was brought forward during the pandemic and services consumption rebounded during the reopening. Households emerged from the lockdowns with record cash balances from government support payments and businesses built up large cash buffers during the post-pandemic profits surge.
This is the first significant Fed tightening when neither households nor businesses are overstretched in terms of debt or interest payments. For that reason, we shouldn’t be surprised that the lag between Fed rate hikes and the economic impact is taking longer than usual. It is possible that we get a soft landing where the economy cools enough to allow the Fed to start lowering rates and prevent a recession. The economy could also get a temporary second wind if receding inflation boosts consumer purchasing power, or manufacturing has a mini recovery as inventories are rebuilt. This no-landing scenario is the most worrying for investors as it would see the Fed contemplate further tightening and risk an eventual deeper recession.
Our cycle, value, and sentiment (CVS) investment decision-making framework is cautious on the one-year ahead outlook for the S&P 500® Index. Valuation is expensive and the cycle is a headwind based on our view of recession risks. Our proprietary sentiment index has returned to neutral levels after signaling overbought conditions in July. Equities could move higher if markets gain more confidence in the soft landing, particularly now that sentiment is near neutral. The economy may, for a time, appear on track for a soft landing even if it slides into recession later in 2024.
Ten-year treasury yields near 4.3% offer good value and recession risks provide cycle support. Our annual outlook late last year nominated 2023 as the year of the diversified portfolio, where a traditional balanced portfolio of 60% equities and 40% fixed income does well. This still looks to be the case.
In the 2016 movie, Sully: Miracle on the Hudson, Sully says that “everything is unprecedented until it happens for the first time”. It would be unprecedented to avoid recession after more than 500 basis points of Fed tightening, but not impossible. We think recession is the likely outcome, but Jay Powell will be hoping for a movie called Miracle on Liberty Street.2
This time is longer, not different
The Sahm Rule3 holds that a recession has started when the three-month moving average of the unemployment rate rises by 0.5 percentage points from its low of the previous 12 months. The rule highlights the self-reinforcing dynamics that take hold once the unemployment rate starts to rise. Rising unemployment signals that firms are belt-tightening. Households become cautious as jobs become more difficult to find. This triggers more austerity and layoffs, which results in further household caution. The process usually starts from the lagged impact of Fed tightening. The Sahm Rule reminds us that it is difficult for the Fed to calibrate monetary policy precisely enough to ensure a policy-induced slowdown won’t slide into recession.
SAHM RULE DEMONSTRATES A NARROW PATH FOR THE FED TO AVOID RECESSION
The U.S. unemployment rate averaged just 3.6% over the three months to August and is the lowest since the late 1960s. By most definitions, this is below the unemployment rate, which is consistent with stable inflation. It is likely that unemployment will need to rise above 4% for the inflation rate to decline to the Fed’s 2% target.
A soft landing is possible, but the Sahm Rule demonstrates the narrow path for the Fed to achieve this goal.
China’s difficult choices
The post-reopening optimism on China has quickly turned to pessimism. The problems are focused on the property market and highly indebted local governments. Property development titan Evergrande has filed for bankruptcy and the largest homebuilder, Country Garden, appears on the verge of default. Consumer and business confidence has collapsed, youth unemployment is over 20% and the economy is flirting with deflation. The government has stopped publishing many statistics that show negative trends. The years of double-digit growth are long past, and the International Monetary Fund now thinks that GDP growth will fall below 4% in the coming years.
The bears argue that the problems are the consequence of China’s unbalanced growth model. Consumption accounts for just 37% of GDP and investment accounts for 42%. In advanced economies, consumption is more than 60% of GDP and investment is under 20%. A key issue is China’s high savings rate, which at 45% of GDP, is much higher than any other major economy and has led to over-investment. The negative view is that China’s unbalanced, state-directed economy has led to excess debt tied to projects where returns do not cover the cost of borrowing.
CHINA: INVESTMENT AND CONSUMPTION
However, a 2008-style financial crisis seems unlikely. China’s major banks are government-owned, debt is mostly domestic with very little foreign borrowing, and capital controls make a capital flight-driven crisis unlikely. A more worrying comparison is with Japan in the wake of the 1980s bubble economy that was followed by decades of sluggish growth and deflationary pressure. The similarities are an aging population, excessive debt, overinvestment in the property sector, and reluctance by policymakers to address bad debt problems.
Investors have been waiting for a significant stimulus announcement, but the approach so far has been a series of gradual interest-rate cuts and some easing of mortgage restrictions. A policy response that would lower the risk of a Japan scenario would involve a transfer of non-performing property-related debt from local governments to the central government combined with coordinated fiscal and monetary stimulus to boost consumption, increase inflation, and reduce national savings. China’s president, Xi Jinping, however, seems reluctant to undertake bailouts and major stimulus because of fears of moral hazard, and that higher debt will increase the risk of financial instability. It seems the economy will need to deteriorate further before there is meaningful stimulus.
China, as measured by the MSCI China Index, has been the worst-performing equity market so far this year, and the index is down by more than 20% from its 2022 peak. It is trading on a 10x forward price-earnings ratio, so has good value, and the investor pessimism on China is encouraging from a contrarian sentiment perspective. Confidence in the cycle is the missing element.
The short-term cyclical outlook is uncertain, but there are reasons for expecting that China can outperform some of the more pessimistic medium-term projections. China’s debt levels are not worryingly high in the context of a developing economy that requires large amounts of investment to increase its capital stock and improve productivity. There is potential for catch-up economic growth and China’s urbanization rate is still below that of countries such as South Korea and Japan at similar stages of development. This can help offset the demographic headwinds. There is also China’s advantage in education. It ranked number one for math and science in the most recent Organization for Economic Co-operation and Development (OECD) Program for International Student Assessment (PISA) results in 2018. China has near-term challenges, but we should not be too pessimistic about its longer-term growth prospects.
We would be positively surprised if Fed Chair Powell is able to stick the proverbial soft landing: a finely tuned slowdown that stabilizes the U.S. economy at around 1% real GDP growth and 100,000 monthly nonfarm payroll growth. History is not favorable to his chances, and we conclude that a recession is more likely than not in 2024.
Whatever transpires on the recession/no-recession debate next year, the uncertainty around market fundamentals is very high. Market pricing, in contrast, has moved squarely in favor of a soft-landing scenario with equities pricing a rapid recovery in corporate profits; credits pricing little concern over rising delinquencies and defaults; and rates pricing gradual cuts back toward a neutral monetary policy stance. As such our cycle, value, and sentiment process favors a slightly cautious approach to U.S. markets, with selective opportunities in quality equities, front-end Treasuries, curve steepeners,4 and agency mortgage-backed securities.
The Eurozone economy is under pressure with Germany, France, Italy, and Spain all flirting with recession. Bank lending and money supply are declining, reflecting the impact of
The ECB lifted the deposit rate to 4% in September and signaled that it may be finished with rate hikes but intends to leave rates at high levels for “a sufficiently long duration”. Markets are challenging the ECB’s higher-for-longer view on the policy rate and pricing nearly 75 basis points of easing over the second half of 2024. We expect markets are likely to be correct given the weakness in key indicators and the downward trend in food and energy prices.
The euro is undervalued and can rise on ECB hawkishness. However, the risk of a policy mistake by the ECB could put downward pressure on the currency over the medium term. Eurozone equities have performed strongly so far this year but will soon face the cycle challenges of tight monetary policy and recession risk.
The UK economy continues to track sideways. The economy, which has barely grown since the beginning of 2022, is still around 0.2% smaller than its pre-pandemic peak in 2019. The Bank of England (BoE) has lifted rates to clearly restrictive levels with the base rate at 5.25% and there are signs that the economy is beginning to buckle. Unemployment is rising and job vacancies are falling. House prices are falling for the first time since the 2008 financial crisis.
Core inflation is proving sticky at near 7% but should start to decline once the growth in wages starts to slow. Markets expect the BoE will be on hold until late in 2024, but we suspect that a sluggish economy could see the bank reverse course earlier in the year.
A hawkish BoE should continue to support the British pound. Large-cap UK equities offer good value but could face headwinds due to their relatively large exposure to health, financials, and consumer staples, and small exposure to technology firms. UK gilts appear attractive with the 10-year yield at 4.4%.
The post-lockdown rebound has boosted the Japanese economy, with services spending back to pre-pandemic levels and inbound tourism recovering. These trends are likely to continue. However, industrial production is softening given China’s weakness, and inventories are elevated, which suggests downside risk to production.
We expect the Bank of Japan (BoJ) will further relax its yield-curve control policy over the next six to 12 months, but an increase in the cash rate will require much more evidence that inflation is sustainably at the BoJ’s target.
Japanese equities have been one of the strongest performers this year, boosted by the cyclical tailwind and some initiatives put in place by the Tokyo Stock Exchange for companies trading at less than book value. Both tailwinds may continue. However, Japanese equities are now more than fully priced in, in our view, and will be sensitive to a global slowdown and any yen strengthening.
The property market struggles and lack of policy response have led to a further slowdown in the Chinese economy. Consumer confidence and spending is soft, and the labor market is showing early signs of softening. There have been several policy responses, largely aimed at improving demand for housing (particularly in the upper-tier cities) and reducing interest rates. However, we believe that more fiscal spending is required and will be provided if the economy weakens further. This spending will likely be more focused on providing support to the consumer through tax cuts, subsidies, or some form of consumption voucher.
The Canadian economy is downshifting. Monthly employment has contracted in two of the last four months and labor-market churn has decreased, as employees less actively switch jobs in response to declining vacancy rates. It seems the surge in immigration has reduced labor market tightness.
Aggressive Bank of Canada (BoC) rate hikes have raised debt service costs and forced households to make budgetary compromises. Rising credit card balances and household insolvencies suggest stress is building. Second-quarter GDP contracted -0.2% versus expectations for a 1.2% gain. The results were disappointing even after accounting for idiosyncrasies such as wildfires and port strikes. GDP per capita has now contracted for three consecutive quarters year-over-year.
The BoC communicated in September that a rate hike pause was appropriate, citing that “excess demand is easing” and the labor market is loosening. Even so, core inflation and wage growth are too far above target, and the BoC conveyed that it is prepared to hike further if conditions warrant. Although an additional hike cannot be ruled out, the BoC is near the end of its rate-hiking campaign as the economy continues to downshift. Nevertheless, the policy rate is expected to stay restrictive until the BoC is convinced that inflation is headed substantially toward its 2% target.
The Australian economy is slowing, but we think recession risk is lower than for the northern hemisphere.
The Reserve Bank of Australia (RBA) policy is not as restrictive as central banks in other regions, and the RBA has probably finished tightening. Approximately 70% of households are now exposed to the increase in the cash rate as many fixed-rate mortgages have expired in the last three months. Immigration-fueled population growth will continue to provide a healthy buffer for the economy, with close to 2% population growth expected over the next 12 months. We expect the Australian dollar has some upside, given it is slightly cheap and will benefit from a compression in interest-rate differentials against the United States. Australian equities trade at a discount to global equities and should benefit if there is more meaningful stimulus from China.
It is hard to be optimistic about New Zealand’s economy given the very restrictive stance of the Reserve Bank of New Zealand. The labor market has started to weaken and the number of applications per job posting has surpassed the pandemic’s peak, indicating that the deterioration is likely to continue. The upcoming general election in October is unlikely to change the economic outlook, with neither party indicating a change in the fiscal stance. New Zealand equities screen as slightly expensive relative to global equities, while New Zealand government bonds look attractive given the cyclical backdrop of heightened recession risk.
Our cycle, value, and sentiment (CVS) investment decision-making framework is cautious on the one-year ahead outlook for the S&P 500. Valuation is expensive and the cycle is a headwind based on our view of recession risks. Our proprietary sentiment index is now at broadly neutral levels from around one standard deviation overbought in July. Markets, however, could melt upward5 over the next few months if investors start to believe that a soft landing is likely.
Enthusiasm for stocks linked to artificial intelligence (AI) has cooled over the last couple of months. Even so, the seven largest technology stocks have contributed 13 percentage points of the 17.3% year-to-date return for the S&P 500 (as of Sept. 15). AI enthusiasm is difficult to predict. Investor enthusiasm for AI-related equities could offset cycle headwinds, but it could also create a larger downside risk if recession fears prick the AI hype.
Our CVS framework provides a positive outlook for U.S. government bonds. 10-year yields near 4.3% are good value and recession risks provide cycle support. Sentiment is more mixed for bonds but on balance provides some support for a contrarian view. Economic data surprises indices are near peak levels and suggest that data could soon disappoint and support bonds. Commodity Futures Trading Commission (CFTC) data continues to show that speculative investors are positioned for yields to rise further.
COMPOSITE CONTRARIAN INDICATOR: INVESTOR SENTIMENT MOVES FROM OVERBOUGHT IN JULY TO BROADLY NEUTRAL
The Composite Contrarian Indicator for investor sentiment is measured in standard deviations above or below a neutral level.
Positive numeric scores correspond to signs of investor pessimism, while negative numeric scores correspond to signs of investor optimism.
Specifically, we have the following assessments at the beginning of Q4 2023:
Equities have limited upside with recession risk on the horizon. Although non-U.S. developed equities are cheaper than U.S. equities, we have a neutral preference until the Fed becomes less hawkish and the U.S. dollar weakens significantly.
Emerging market equities have underperformed developed markets so far this year. Concerns about China’s economy have been a headwind and these worries seem unlikely to lift over the near-term. For now, a neutral stance is warranted. Emerging markets usually deliver stronger returns when the U.S. dollar is declining. This may be delayed until 2024 when investors start anticipating the Fed will lower interest rates and the dollar declines in response.
High yield has rallied on soft landing expectations and the spread to Treasuries is below the long-term average. Investment grade credit spreads are closer to their long-term averages. The poor cycle outlook is a challenge with default rates likely to rise as U.S. recession probabilities increase.
Government bond valuations are attractive. U.S., UK, and German bonds offer reasonable value. They have the potential to rally as investors become confident that central banks have finished tightening, inflation has peaked, and economies are slowing. It is likely the U.S. yield curve can steepen in the coming months. The spread between the 2-year and 10-year bond yields is close to an extreme. The yield curve tends to steepen after the Fed has completed raising interest rates and markets start looking toward monetary easing. Japan remains the exception, where the 10-year yield is around 70 basis points and still expensive.
Real assets: Real estate investment trusts (REITs) and infrastructure have attractive valuations compared to global equities. While the office sector faces challenges, it is only a small portion of the overall REIT market. The end of Fed rate hikes should favor REITs over equities. Oil has benefited from the OPEC+ supply cuts to push toward $100 per barrel. The upside appears limited, however, given the subdued Chinese economy. This should also weigh on agricultural prices and base metals. Recession risks for developed economies are a further headwind.
The U.S. dollar (USD) has strengthened over the past couple of months as investors speculate the economy could have a soft landing that would delay rate cuts. The dollar is expensive in real trade-weighted terms and will be under downside pressure if markets lose faith in a soft landing. The Japanese yen is attractive from a cycle and value perspective. At 147 versus the USD, it is significantly undervalued relative to its purchasing power parity valuation of 92. Japanese inflation pressures mean the Bank of Japan is likely to eventually move away from yield curve control monetary policy. The euro at 1.07 is also significantly undervalued relative to its purchasing power parity value of 1.36. It will appreciate, however, only if markets expect that recession and ECB rate cuts can be avoided.
ASSET PERFORMANCE SINCE THE BEGINNING OF 2023
1 The Miracle on the Hudson refers to a US Airways flight that lost all engine power after striking a flock of birds shortly after take-off from New York’s LaGuardia Airport in 2009. The pilots glided the plane to ditching in the Hudson River, where all 155 people on board were rescued by nearby boats. A National Transportation Safety Board official described it as “the most successful ditching in aviation history”.
2 The Federal Reserve Bank of New York Building in New York City is also known as 33 Liberty Street.
3 The Sahm Rule is a measure for determining when an economy has entered a recession. It was devised by Claudia Sahm, a former Federal Reserve economist.
4 A curve steepener trade is a strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities.
5 A melt-up is a sustained and often unexpected improvement in the investment performance of an asset or asset class, driven partly by a stampede of investors who do not want to miss its rise, rather than by fundamental improvements in the economy.
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