Markets in limbo over mild or deep recession as chasm opens between governments and central banks

As central banks keep tightening and major economies contract around the globe, a recession seems inevitable and chances at a swift recovery are dwindling. But will we see a mild or a deep recession? The answer to this question harbors important insights for investors on whether to hunt for opportunities or rather avoid risks. Even if systemic risks are currently low, misaligned fiscal and monetary policies undermine the potential for a soft landing by exacerbating the market's high sensitivities to mixed signals from governments and central banks.

Since the beginning of the year, central banks have quickly escalated their monetary policies with more front-loaded and bigger rate hikes than expected, robbing the market of central bank support which had been (foolishly) taken for granted. On Wednesday last week, the U.S. Federal Reserve (Fed) reiterated its hawkish stance, contemplating an interest rate increase of 75 basis points at their meeting next month, amidst increased warnings that the global economy is coming under severe stress. The Fed rightfully remains firm on inflation as US inflation numbers for September have come in a tad higher than what was expected (8.2% vs 8.1%). Reacting to the complex interplay between inflation and growth, the International Monetary Fund recently issued a warning that the “worst is yet to come”¹  for the global economy. Whereas a mild recession seems to have been priced in already, a harder-than-soft landing would trigger further corrections in valuations and cannot be ruled out as things stand today.

Rifts between governments and central banks as main risks

Sure, systemic risks in today’s economy are limited compared to 2008 since banks have built sizeable equity capital cushions and household leverage – in particular in the US – is far from worrisome. However, the main reason for the risk of a deeper recession is the threat of an increasing misalignment between monetary and fiscal policies in major economies and the markets’ reaction to it. What happened recently in the UK serves as a prime example: The UK's new conservative government’s proposal for an unfunded tax cut of GBP45 billion British pounds in late September made the Bank of England vow to counteract any expansionary fiscal policy measure by further monetary tightening. In a similar vein, investors were quick to discredit the “mini budget” by dumping UK assets in a major market rout which wreaked havoc on UK bond and FX markets as well as equity markets, albeit to a lesser extent. In today's interconnected financial markets, such incidents have the potential of spilling over to other countries and create domino effects across entire continents, especially since financial markets and the global economy have become more fragile against the backdrop of increased geopolitical tensions, a full-fledged energy crisis and soaring inflation.

Other countries are playing with fire too. The US has announced a massive student debt relief program that would cut loan repayments by as much as 20 000 US dollars for some recipients. In total, the program would forgive about 500 billion US dollars in debt.  Germany, Europe’s biggest economy, plans to borrow 200 billion US dollars to cap energy prices for households and businesses. Italy’s new conservative government has already pledged tax cuts as part of its campaign. Moreover, the idea of eurozone bond issuance seems to gain traction. Expansionary fiscal measures such as these contradict the agenda of central banks that have zoomed in on bringing down inflation. Therefore, it is likely that any indirect liquidity injections by governments will be swiftly absorbed by more rate hikes by central banks which could eventually lead to overtightening thwarting growth and deepening the recession.

In addition, the fact that markets took the UK's tax move so badly does not bode well for countries where governments and central banks pull in opposite directions. This is because the reaction is reflective of high levels of fragility in the market that have translated into higher correlations between equities and bonds that have seen drawdowns of similar magnitude this year. Our analysis has shown that only when inflation is below 3%, can equities and bonds potentially decouple to take different paths again and return to their role of providing strong diversification potential in portfolios.

All eyes on the current earnings season

How fragile the market will continue to be also hinges on the quality of the current reporting season. In particular, it depends how much confidence CEOs of market-defining large caps, like Apple, can project and how well they can communicate their expectations on maintaining their margins for the remainder of the year as well as 2023. Current EPS consensus estimates still seem conspicuously robust against a deteriorating economic background. Should the current earnings season disappoint, and should corporate leaders not be able to instill trust in their companies’ strategies and positioning, EPS estimates may eventually have to be revised downwards which would likely be unwelcome news to an already destabilized market.

Protecting wealth rather than seeking opportunities

We can all agree that inflation must come down to restore health to the economy and markets so that correlations can decrease and central banks can stand back. As contradictory fiscal policies won’t be helpful in this endeavor, such behavior will be penalized by central banks and markets alike which harbors the risk for overtightening and more tumults. As long as economies are still in limbo over how deep their recessions will be, investors’ portfolios should focus on wealth protection by favoring shorter duration bonds over longer duration ones as the latter are more correlated with the equity markets and exhibit high interest rate sensitivity. Even if more rate hikes are in the offing, the short end of the interest rate curve has already priced in a lot with the potential of protecting investors from further turmoil in bonds. In equities, quality and value stocks provide more stability and inflation hedge than growth titles over the coming months. Recently, going long the US dollar has been a powerful trade although it is slowly losing momentum as it is getting expensive against other currencies. The good news is that once we can count on a mild recession, there are plentiful opportunities to be reaped in equity markets as well as the corporate and high-yield markets within fixed income as prices pick up again and spreads tighten.