If and when a global recession emerges, expect a sell-off in both equity and credit markets.
We don’t see much respite for investors as we look ahead to next year, despite 2022 having been a turbulent year. However, we also anticipate pockets of opportunities to capitalise on.
The headwinds of high inflation, the energy crisis and geopolitical tensions that have plagued markets this year cast an ominous shadow heading into 2023. Recession has already begun in some major economies, and we expect a US-led global recession to take hold over the next six months.
Central banks – the US Federal Reserve in particular – are leading us there through aggressive tightening of monetary policy, combined with a huge terms-of-trade shock in Europe and the drag of lingering zero-Covid and property-sector weakness in China.
However, only parts of the capital market have fully priced in a global recession in the first half of next year – the US bond market with its inverted yield curve being one of them. More recently, bond yields have been falling and credit markets as well as equity markets are holding on to the possibility that the Fed can engineer a soft landing.
Credit spreads across US corporate high yield have widened since the start of the year and were sitting at around 500 basis points as at the end of November – a level that reflects some of the risks, but maybe not all of them.
The primary driver of financial markets is shifting from policy normalisation to demand destruction. Higher rates to tame inflation are creating headwinds for consumers and companies. The former are confronted by higher mortgage and borrowing rates, while the later face higher financing and input costs. Both serve to constrain spending.
But while expectations for earnings growth have come down, they remain elevated. We suspect that equity markets have further to fall, even if sentiment has buoyed certain markets amid an over-eagerness to see inflation as having peaked in the US.
This reaction misses important details, in our view. It will be base effects and an easing in supply-chain bottlenecks that drive a moderation in global inflation to begin with. Yes, headline global inflation is passing its peak. Oil prices are about 30% below recent highs, while European gas prices are down thanks in part to unseasonably warm weather.
But we think core global inflation will prove stickier. Vacancy and quit rates in the US are elevated, while wage pressures remain high. Inflation expectations across developed markets are higher now than before the pandemic.
Our research suggests that taming core inflation in developed markets will require a rise in unemployment consistent with recession. Higher unemployment will weigh on wage growth and inflation expectations. Ultimately, that means more rate hikes.
It’s what Fed policy committee members indicated recently by suggesting the market was getting ahead of itself and that terminal rates needed to be higher than previously anticipated.
In fact, we suspect the Fed is more likely to over-tighten rates to control inflation than anything else. Having erred in its messaging earlier this year by calling inflation transitory, it won’t want to subject itself to accusations of further policy mistakes.
But even if a global recession does transpire in the first half of next year, we still anticipate pockets of opportunities. One of those is in rates, where a flight to quality would likely see yields across US Treasuries fall – potentially resulting in positive gain for the asset class.
Earnings pressures aren’t fully reflected across global equities, which underpins our more cautious views around the asset class. We think there are regions better positioned to weather the recession. Asia Pacific, for example, isn’t facing the same inflationary pressures and so should be more resilient.
At the same time, the Reserve Bank of Australia is further through its rate-hiking cycle than most countries, and domestically we’re expecting inflation to peak this month. Terminal cash rates in Australia are also expected to peak at a reasonably lower rate than in the US. This leaves Australia well-positioned in a global context.
For its part, China is on a different monetary policy path than the rest of the world. Inflation has not run rampant, with the People’s Bank of China easing rather than tightening rates. This presents a unique counter-cyclical opportunity for investors.
While adherence to a zero-tolerance approach to Covid could continue to drag on China’s economic growth, conditions appear to be easing amid renewed flexibility on some Covid policies and more vaccinations for the elderly. We have long been proponents that China is on a pathway to gradual reopening, although we can expect some speed bumps along the way until zero-Covid is abandoned.
Additionally, government support for China’s property sector is welcome. Chinese equities have just about halved since their highs of last year, meaning the risk-reward balance from these levels is now better than for US stocks. But again, investors need to be mindful that any reopening will be gradual.
All told, we envisage that multiple overlapping headwinds will drive a global recession in the first half of next year, leading to a moderation in inflation and interest rates returning to a lower bound. Our global GDP forecasts for 2023 (0.7%) and 2024 (1.5%) remain below consensus.
If and when a global recession emerges, we would expect a sell-off in both equity and credit markets. We could also see US Treasuries rally. A rebound in global equities, and a fall in global corporate and sovereign credit spreads, will come eventually, although not until we’re further through the global recession.
Irene Goh, Head of Multi-Asset Investment Solutions, Asia Pacific at abrdn
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