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After a very difficult year in 2022, many developed economies started 2023 better than expected. The challenges faced last year, such as rising inflation and interest rates, seem to be behind us now – with the exception of the UK, where inflation is expected to fall in the second half of the year.
While rising inflation and rapid interest rate hikes might be subsiding, we could see new challenges emerging as a result of them. And investors have a likely US recession and declining corporate earnings to contend with.
Despite these challenges, markets have turned in a relatively positive performance over the first half of the year. But we’re basically seeing a lot of mixed messaging from the macro-economic data at the moment.
On the one hand we have oil prices falling despite supply cuts – indicating subdued demand, rising financing costs for consumers and businesses, and small US companies’ optimism at a decade low. While on the other hand, US and European growth is better than expected and corporate earnings are beating forecasts – albeit still falling.
Meanwhile, the bond market is already pricing in a much weaker growth and inflation environment in the coming months, with an expectation that interest rates will make a U-turn and start dropping soon, something that would typically only occur during a recession.
In our Investment Outlook at the beginning of the year, we said we believed a US recession would be the main story of 2023. This remains the case – we still believe such a recession is likely. Our own recession indicator suggests one is on the way in the next 12 months. And in the past, when our indicator has been at the levels it’s at now, a recession hasn’t been far away, as you can see in the graph below.
The drivers behind the elevated indicator include an inverted yield curve (when short-term bond yields are higher than long-term yields), declining building permits and a weak consumer sentiment and manufacturing outlook.
Another factor we’re monitoring closely as a potential indication of an imminent US recession is the country’s labour market. The US economy is heavily consumer focused – so a recession can’t come until there’s a rise in unemployment and consumption declines as a result. History has shown that the labour market tends to deteriorate as we near a recession, or just as one has started.
There is a possibility, however, that a strong labour market will support consumer demand and either delay the start of a recession or allow the economy to simply avoid one. The presidential election in 2024 could also play a role in averting a recession – as having one isn’t very conducive to getting votes – and the government could use fiscal policy to sustain a healthy level of economic momentum.
The difficulty with these more benign scenarios is that they would likely prevent inflation from falling back to central banks’ preferred levels of 2%. It’s generally accepted that something needs to happen to reduce demand for goods and services for price pressures to decisively fall back to pre-pandemic levels.
In a bid to tame above-target inflation levels, central banks have been raising interest rates at a rapid pace. And regardless of whether or not a recession is on the way, higher rates can shock the system and expose vulnerabilities. We’ve seen this in the US, where the Federal Reserve’s aggressive rate hiking unearthed concerns around systemic risks in the US banking sector. While those concerns were soon allayed, we’re still starting to see cracks in some interest-rate-sensitive sectors.
Meanwhile, people appear to be eating away at their pandemic savings and taking on debt to keep up with inflation. As a result, a growing number of people are missing payments on their credit cards or car loans as they can’t keep up with rising costs. In the US, for example, the average used car loan payment for consumers is up 35% compared to its equivalent at the beginning of 2020, according to Citi and Cox Automotive. America’s low unemployment rate has been key in containing the impact of this. But once the labour market begins to deteriorate, consumer spending could decline, and with it the economy.
So how is all this affecting one of the key cornerstones of investing – company performance? Well, despite some challenges over the past six months, companies are actually faring better than expected.
Coming into 2023, company earnings were expected to drop significantly. But in the first three months of the year, they beat these – admittedly low – expectations. Earnings growth was expected to fall by 8%, but at the time of writing it had only fallen 3%.
While this may seem like relatively good news, it does follow a 2% decline in Q4 2022. Also, analyst forecasts predict a 6% drop in Q2 this year, before flattening in Q3 and then finally rebounding to be up 7% in Q4.
This is a peak to trough of -3% between Q3 2022 and Q3 2023, which is by no means disastrous when compared to previous contractions in the past 50 years. Following the Global Financial Crisis in 2008, for example, US earnings contracted by roughly 50%.
As we know financial markets have been under pressure for 18 months, we favour a cautious approach regarding our investments.
For now, we’ve tilted our portfolios away from risk-sensitive assets and have a more positive bias towards government bonds. We do, however, think opportunities will present themselves later this year, which are likely to include small-cap stocks, emerging market equities, and perhaps even the banking sector.
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We regularly update our articles depending on what’s happening in the market so check back for future updates.
