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Can the Fed correct course as recession risks loom?
As inflation is digging in its heels, employment markets are tightening up and economies are contracting around the globe, investors are faced with the uncomfortable truth that the Fed might be behind the curve. Now, much depends on whether the central bank is able to correct course to soften the landing for contracting economies or whether an overly hawkish turn will stifle growth causing recessionary tendencies to worsen.
Misled by the “temporary-inflation” assumption based on the hope that supply chain bottlenecks would resolve in a reasonable timeframe, the Fed might have been too lax on policy normalization. Not only was it a mistake to keep buying bonds last year when the economy was approaching its peak, but also to increase interest rates by only 25 basis points (bps) at the last FOMC in March. As a result, a 50 bps rate hike this week can be taken for granted as the Fed tries to get back on track. While front-loading its rate hiking strategy is a good first step towards restoring credibility and market order, it might not be enough to regain full trust of investors who have been fretting over the Fed's policy for months. If the Fed does not manage to push inflation back towards 2% over the next two years, US bonds markets may feel long-lasting effects in terms of higher yields. This would provide ammunition to US dollar bears, who argue that the US dollar and US Treasury market could see their safe-haven status diminish over time.
Currently, we are facing the tightest labor market since the 1950s by many indicators. Our proprietary business cycle model Wave is indicating that not only US employment levels are rising but also labor force participation is increasing which has been translating into wage growth. This is a nefarious second-round effect indicating that inflation is becoming sticky. While the Fed will most certainly make a sizeable move on rates now, it is doubtful if they will really get to the expected 2.5% interest rate level over the remainder of the year. This is because, on the surface, interest rate levels do not fully reflect the effects of quantitative easing and tightening on financial markets. So-called shadow rates capture these effects more accurately and currently put the effective interest rate in the US below -5%. As a result, the Fed is unlikely to go beyond 1.5% by the end of the year as negative effects of the tightening cycle are likely to have become apparent by then.
Also the ECB is in a pickle
Even if the pressure on the Fed to take immediate action is higher at this instance, the ECB ultimately has a much harder job to do. In comparison to the Fed, the ECB faces higher supply-side inflation pressure which cannot be tackled with simple rate hikes. In the Eurozone, producer prices have increased by 31% year-on-year in February. This is a reflection of supply side bottlenecks and the Ukraine-Russia conflict, which is threatening growth via energy supply shortages. Time might be on the ECB's side for once since inflation has not fueled wage growth just yet. Therefore, the ECB has been prudent to adopt a wait-and-see strategy as it juggles the effects of the war, energy shortages, COVID-19 aftereffects, and growth. There is one caveat though: Should the euro continue to weaken against other major currencies, the ECB might be forced to act in an attempt to prop up the currency.
Recession question hinges on central bank prudence
While central banks are in hot water, many economies are contracting and attempting to stave off full-fledged recessions – a risk which is mainly fueled by strained energy and overheating labor markets. An ECB study has revealed that if energy supply falls by 10%, GDP is likely to be lower by 0.6%-points1. Even if the market already prices in more than that, there is a risk that the situation in Ukraine escalates further as Russia increasingly perceives NATO as party to the war.
According to the Wave, we are globally in an advanced stage of an economic downturn with most countries signaling contraction. On average, downturns last about 20 months while contractions account for seven months of that time period. We are currently in month four. There are exceptions to this rule like the bursting of the dotcom bubble which triggered a contraction of 15 months. However, longer contractions usually build on structural vulnerabilities in the economy such as a large number of equity heavyweights being overvalued despite shallow earnings or real estate markets running hot paired with high leverage in the banking sector. Often, contractions end with central bank policy shifts, like in 2018, when an indication of a potential rate cut turned economic sentiment around. Even if the current market is not as fragile as in the 2000s, central banks committing another policy error by raising rates on autopilot could plunge the US and Europe into recessions.
Emerging markets also start feeling the heat of rising US yields while some countries, especially in Latin America, are still benefiting from elevated commodity prices. The question is, however, how long profits from commodity prices can stave off recession jitters that are creeping in through worries about rising servicing costs on outstanding US dollar debt. Emerging economies in EMEA are currently affected the most by the ongoing Russia-Ukraine conflict and the worsening energy supply situation as Poland has now been cut off from Gazprom's natural gas exports. Asia's outlook has also deteriorated due to renewed COVID restrictions in China. But fortunately, there is light at the end of the tunnel. Relatively moderate inflation pressure allows the PBoC – as one of the few central banks in the world – to ease monetary policy. Sectors, on which the government has a tighter grip, such as the real estate market and infrastructure, show signs of stabilization already as past stimulus packages start to arrive in the economy. Moreover, last week's Politburo meeting has left little doubt that more sizable policy measures are coming.
Value to be found in spreads and equities
Despite looming recession risks, spread products in fixed income markets still look attractive whereas duration risk should be avoided which warrants positionings at the short end of the curve. Short-dated Italian government bonds might not offer much on spreads but can have value from a total return perspective. Declining EM asset prices in emerging markets moves buy-and-hold investors with long-term investment horizons closer to attractive entry levels although exogenous factors such as mounting geopolitical tensions need to be taken into consideration. On the equity side, style diversification across value, quality and growth has merit in our view. Even if quality stocks appear expensive, they provide stabilizing effects in case of rising interest rates thanks to sound company balance sheets. Growth might be suffering right now but is likely to still offer upside as interest rates are unlikely to rise that much. Value with a defensive tilt can make up for lost income on the fixed income side by virtue of a stable dividend yield, in particular if the economic outlook worsens. Gold makes sense as a hedge while commodities will have to prove their case should economies enter recessionary territory.
