Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Macro Insights: Weighing the odds of a recession
Charu Chanana
Chief Investment Strategist
Summary: The ‘recession’ chatter is buzzing high these days, and a host of indicators have started to point towards an economic slowdown. Global credit impulse, US leading economic indicator, slowing new orders are some of the warning signs, but consumer and corporate balance sheets are still strong. While it remains hard to define a recession, there are some reasons to believe that economic slowdown will take the limelight away from ‘inflation’ next year. Equity markets, however, do not price in this demand slowdown risk yet, and investors are rather chasing the income opportunities offered by bonds.
It was exactly one year back when the Fed accepted that inflation is more than ‘transitory’. And we have seen the effects of that shift reverberate through the markets all this year. However, even with indicators pointing towards some signs of cooling in price pressures, it will be premature to take comfort. The Fed especially understands that, having learnt from the 1970s experience when inflation came roaring back as monetary policy was eased prematurely.
The focus, however, is now shifting towards recession concerns with several indicators pointing to weakening in demand conditions going into 2023. Let’s take stock:
- Global credit impulse, which represents the flow of new credit issued from the private sector as a percentage of GDP, is usually a good leading indicator for S&P earnings growth and has started to show a decline. See page 30 of our Macro Strategist Chris Dembik’s Macro Chartmania.
- The Conference Board leading indicator has dipped to -2.7, down 0.8% m/m as noted by our Equity Strategist Peter Garnry here.
- New orders are dropping, whether you look at Empire State manufacturing survey, or Philly Fed survey, or yesterday’s flash S&P manufacturing PMIs for the US.
- US banks are tightening lending conditions on loans for medium and large businesses and for commercial real estate. Lending standards for credit cards and other consumer loans also became more restrictive.
- Housing market has been flashing a warning sign for some time, and risk of job losses remains high. Given that this will be a high % of GDP and employment, it could be well reflected in headline figures unlike the tech sector layoffs which are a small % of total US employment.
However, there are also reasons to believe that any recession, if one was to happen, will be in nominal and not in real terms. Real growth will remain supported by falling inflation levels. The other key counter-argument usually is that US households and corporations still look fairly flush with cash following the pandemic-era savings and stimulus.
Whether we enter an official recession as defined by NBER remains tough to argue, but indicators suggest we have a case of demand slowdown building up. Two key things are important to monitor:
- The pace of slowdown in earnings growth
- The pace of deterioration in the US jobs market
This suggests calling an end to the bear markets may still be premature, as equity markets still need to price in a recession risk. The S&P500 is still trading at a P/E of 18.2x, higher than the average of 17.4x since 2000. It is probably best to play defensive and get exposure to value still rather than growth sectors which can have a lot more downside still. Meanwhile, investors have started to chase the high yields and income opportunity offered by fixed income after a massive jump in interest rates seen this year. Shorter dated and higher quality investment grade fixed income offers attractive income and capital gain opportunities.
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