The author is Global Chief Investment Officer at Credit Suisse
In keeping with the great traditions of the financial industry, this year is a time to predict the health of the global economy and what to do with the collective wisdom of investors.
In examining the economic and investment outlook of various banks and asset managers, many found an overwhelming consensus about a recession next year in the world’s largest economy.
According to this script, a US recession in 2023 would lead to a sharp slowdown in inflation, allowing the Federal Reserve to stop raising rates and then — at a later stage — start cutting rates to solve the problem. It should be. This script is familiar from the US recession of the early 1990s, 2001 and 2008. What will inevitably follow is a rally in the stock market, with investors living again for the next cycle.
However, it is somewhat jarring that both market observers and market participants are currently converging on this rather optimistic assessment. I must be missing something. So what could go wrong with this script? At what point does it go from “same this time” to “different this time”?
There are strong reasons for the expectation of consensus. Growth is already slowing rapidly. The Eurozone and the UK are already in recession, and US growth is slowly slowing. US inflation has peaked and the Fed is determined to fight it, meaning it could fall further. This economic outlook is also tightly priced by financial markets.
The most visible sign is certainly a sharply inverted yield curve, with short-term Treasury yields higher than long-term Treasuries. Since the 1960s, it has been a reliable predictor of impending recession. At the same time, an inverted yield curve suggests to market participants that inflation is likely to fall and that the central bank will (at some point) cut interest rates to re-support growth or calm market turmoil. It reflects expectations. So the fact that the curve is currently inverting so deeply also means that investors are hoping inflation will normalize soon, and the Fed may be able to cut rates sooner or later.
Still, there are factors that go against the current consensus expectations that deserve consideration. First, when it comes to economic growth, the US recession could be much later than many expected. The U.S. economy is less exposed to Fed rate hikes than it has been in the past. Today, most homeowners have fixed-rate mortgages, and businesses are taking advantage of the low interest rates of the past few years to raise long-term financing.
Households and businesses will feel the effects of rate hikes with a longer time lag than usual. So while growth is already weak, a tumble into a full-blown recession may be something Godot is waiting for. This is in stark contrast to the rapid recession/rapid recovery pattern that the market seems to be expecting.
Second, when it comes to inflation, it may be more entrenched than expected. Inflation, especially in wage growth, appears to have stalled due to a shortage of skilled workers. The new multipolar world order will force structural changes in the economy, such as the need to rebuild reliable supply chains closer to home, often at high prices. Similarly, the urgent need to decarbonize could exacerbate “greenflation”, i.e. higher prices for environmentally friendly goods and services.
All this means that inflation could fall much more slowly than many of us (including central banks) would like. may also find themselves in a situation where they have to maintain interest rates because of inflation.
This would be negative for the stock market, as the first market rebound after a recession is often triggered by rate cuts. The Fed’s “put” (the Fed’s willingness to help markets during times of high volatility) will be lost forever, and the way out of the recession will be financial, not financial.
These reasons make the current market consensus very uncomfortable. There is a risk of longer periods of lower growth, higher inflation and weaker stock markets than during past economic slowdowns. Investors are therefore encouraged to diversify their portfolios, including a sensible allocation to fixed income. Alternative investments such as hedge funds and private equity can also be a way to manage portfolio risk.
Indeed, investors should remain cautious next year and act as if the Fed’s puts are no longer working. I mean, this time it’s really different.