CPD: Recession… what recession?

Since August of 2022 the Bloomberg consensus has placed a probability of 50% or more on a US recession occurring within the next 12 months. However, despite 525 basis points of tightening and a still hawkish Fed, a soft landing appears increasingly likely. This article from GSFM’s investment partner TD Epoch explains what underpins the US economy’s surprising strength.

Epoch believes there are three reasons why US activity has held up better than expected: the lingering impact of the aggressive COVID stimulus packages, the renaissance of industrial policy (which has led to a manufacturing construction boom), and the still accommodative stance of broader financial conditions.

COVID stimulus drove excess savings

The US response to the COVID recession was fast and furious. As a result, personal income and savings immediately soared (figure one). While this stimulus provided a tremendous impulse for consumption over the last three years, it has by now been entirely spent.

 

Industrial policy renaissance: booming manufacturing construction

The second reason is that industrial policy has returned, after a fifty-plus year hiatus, with the August 2022 passage of both the $280 billion “Chips and Science Act” and the $400 billion “Inflation Reduction Act” (the latter is horrendously misnamed as it primarily incentivises green technology investment).

One direct beneficiary is manufacturing construction, which is up 101% year-on-year, with the electronics sector especially strong (figure two). Moreover, industrial policy spending is likely to remain robust through 2023, as these expenditures have been approved by Congress.

Overall fiscal spending, for which industrial policy is a component, has provided significant oomph for the economy in 2023, contributing roughly three percentage points of GDP. This has offset much of the Fed’s efforts over the last eighteen months, but fiscal expenditures are set to tighten over the next two years. To illustrate, consensus expects government spending growth to slow from three percent this year to one percent in 2024 and 2025^[1]. This implies a significantly negative fiscal impulse coming down the pipeline.

Overall financial conditions vs the Fed Funds Rate (FFR)

Third, while the FFR has skyrocketed, the same can’t be said of broader financial conditions, which are unchanged compared to July of 2022 (figure three).

To illustrate, the 10 year yield is a bit lower than it was last October and the high yield spread is narrower than its level of a year ago (figure four).

The relatively accommodative stance of overall financial conditions helps explain the resilience of both the consumer and corporates. To illustrate, the US household debt service ratio is only 9.6 percent of income (figure five). This ratio is not only below the 1980-2019 average of 11.2 percent, but beneath the lowest rate hit during that period (9.8 percent).

The situation is even more extreme for US businesses (figure six). Moreover, corporate refinancing needs over the next two years are historically low, reflecting their issuance of so many bonds in 2020 and 2021 when rates were rock bottom. In fact, only 16 percent of corporate debt is slated to mature over the next two years.

However, refinanced corporate debt will pay, on average, an additional 1.5 – 2.0 percentage points above existing rates. This will boost interest expense by around two percent in 2024 and five percent in 2025, and likely have a marginally negative impact on capex, hiring, and so on.

The relatively light interest burden facing consumers and businesses helps explain the surprising strength of the US economy. However, the bad news is this means the Fed needs to maintain a hawkish stance until financial conditions tighten enough to tame hiring, services consumption, and wage growth. 

Will we ever get back to target inflation?

Until this year, the bond market expected the Fed to cut twice to a 4.5 percent policy rate by December 2023 after reaching a peak rate above five percent in June 2023. The Fed has consistently insisted that it would not cut rates this year, but the bond market ignored the message. However, after stellar jobs numbers in early 2023, investors had to concede that rate cuts may not happen until 2024. And after several inflation releases that showed “sticky inflation”, investors began to worry that central banks may never again hit their two percent inflation targets and that we should brace for “higher for longer” rates.

Once US regional bank concerns emerged in March, markets went back to pricing in rate cuts for the second half of 2023. However, this time, investors expected four cuts. Then, after some swift, policy assisted regional bank takeovers, concerns over broader financial contagion dissipated and investors, once again, turned their attention to inflation that has defied expectations by normalising at a “slower than expected” pace. So, today, investors are moving back to pricing out 2023 rate cuts as central banks continue to tighten monetary policy, albeit at a slower pace.

Although the global financial system concerns that have emerged since March certainly add another layer of uncertainty around the future path of inflation, the continued tightening in global monetary policy may seem intuitive based on prevailing inflation levels. However, even before banking stresses came to the forefront, continued rate hikes were surprising when we consider that leading economic indicators have been signalling that a recession is coming. But is it?

Three scenarios for the next 12 months

With wage growth still over five percent and core inflation north of four percent, Epoch expects the Fed to retain a tightening bias for at least the next two quarters. While so much tightening, over such a short period, would normally have ensured a recession, nothing about this cycle has been normal. Moreover, forecasting nonlinear events like recessions is a mug’s game. That is why Epoch advocates humility and has adopted a scenario- based framework.

Investors always price in a soft landing (and occasionally they’re correct)

The first scenario calls for a soft landing (50 percent probability), similar to the experiences in 1984 and 1995. This scenario appears to be the current market consensus, which is not unusual as investors always expect a soft landing when the Fed is nearly done tightening.

A soft landing implies sub-trend but positive GDP growth, inflation stuck at three percent, a hawkish pause from the Fed and EPS growing by mid-single digits. This scenario also suggests a choppy S&P500, with “fat and flat” (i.e. choppy but directionless) equity returns. Previous soft landings were terrific for equities, but this time valuations are already quite stretched, which is likely to put a cap on further upside.

The second outcome involves a “short and shallow” recession (40 percent likely), with slightly negative GDP growth, inflation decelerating below three percent, Fed cuts of 200-300 basis points and EPS declining by five-to-ten percent, but recovering quickly, within a couple quarters. For equity markets, this could be similar to the 1990 recession in which the S&P500 declined sharply for two months, but then experienced an impressive V-shaped recovery.

When the Fed hits the brakes, someone almost always goes through the windshield. The third scenario is a hard landing (10 percent chance), in which something breaks, creating a credit event that cascades across financial linkages and results in a freezing of funding markets. This is what happened on a massive scale in 2000-2002 and 2007-2009, although this time the imbalances are much less extreme (figure seven).

In a hard landing, GDP growth would be negative for an extended period of time, and EPS would slump by well over 15 percent. In such an outcome, the Fed would be focused on financial stability rather than inflation and would quickly slash rates (by over 300 basis points). Equity markets could plummet by 15-30 percent, with a relatively slow L-shaped recovery.

While it is extremely difficult to know which of the three scenarios is unfolding, we believe there are four key recession indicators to watch like a hawk:

1. The Fed’s Senior Loan Officer Survey, which is already close to recessionary levels and implies much weaker consumer and commercial and industrial lending, as well as dramatically wider high yield spreads and significantly negative capex growth.
2. The non-performing loans exposure of small banks, which account for 68 percent of commercial real estate loans (but only 38 percent of overall lending).
3. Default rates on high yield and leveraged loans, which have inched up to 2019 levels but aren’t yet anywhere near levels consistent with a recession.
4. Consumer delinquencies, as they are creeping higher, especially for auto loans and credit cards.

Investment implications

The US economy has been much more resilient this year than consensus had expected. However, most of the reasons for this surprising strength are fading. Moreover, the economy’s durability has forced the Fed to maintain a hawkish stance, to ensure inflationary pressures don’t reassert themselves.

It is also critical to keep in mind that monetary policy works with a lag that is famously long and variable. The Fed just started hiking 17 months ago and in previous cycles it has taken considerably longer (typically 21 to 42 months) for the tightening to bite. This suggests the possibility that the current cycle might not be that different, it’s just that the federal funds rate is a crude tool and takes a long time to produce its desired effect.

Epoch believes a short and shallow recession is 40 percent likely and assigns a 10 percent probability to a hard landing. However, it is impossible to have high conviction regarding the timing and depth of an eventual downturn. Rather, the scenario-based approach is preferred, one which favours a cautious stance, focused on quality companies with a demonstrated ability to return capital to shareholders and/or to produce a return on invested capital in excess of their cost of capital.

By William Priest, CFA, Executive Chairman & Co-Chief Investment Officer, and Kevin Hebner, PhD, Managing Director, Global Investment Strategist, Epoch

 

Take the FAAA accredited quiz to earn 0.5 CPD hour:

CPD Quiz

The following CPD quiz is accredited by the FAAA at 0.5 hour.

Legislated CPD Area: General (0.5 hrs)

ASIC Knowledge Requirements: General Knowledge (0.5 hrs)

please log in to start this quiz

 

———

[1] This reflects the 3 June “Fiscal Responsibility Act”, part of the debt limit deal, which sets a cap on federal discretionary spending for 2024 and 2025

Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.