Is the US Economy Heading into a Recession?
Prashant BHAYANI CIO Asia, Grace TAM Chief Investment Advisor, Hong Kong & Dannel LOW Investment Specialist at BNP Paribas Wealth Management
Summary
- The probability of a US recession next year stands at 65%, in our view.
- We will not be surprised to see any bear market rally, but we still worry about further downside probably next year due to higher real yields, tightening financial conditions and the potential risk of a credit event.
- Furthermore, a US recession scenario has not been fully priced in as the extent of drawdown, credit spreads, corporate earnings estimates, PE multiplies and fund flows are yet to adjust to historic recessionary levels.
- Investors should stay defensive and diversified with a focus on quality and income to navigate continued market volatility.
Recession risk has escalated
The US economy grew at +2.6% (qoq saar) in 3Q after a technical recession in 1H with 1Q and 2Q GDP showing negative growth of -1.6% and -0.6% respectively. Although the US headline CPI inflation may have already peaked at 9.1% in June, the core inflation has proved relatively resilient, which means that the Fed has to raise rates further to a more restrictive territory at the expense of growth, or even leading the economy into a downturn. The probability of a US recession next year stands at 65%, in our view. We forecast potentially negative GDP growth in the 2Q through 4Q 2023.
The Fed “pivots” to slower rate hikes but no dovish cuts in 2023
As expected, the Fed delivered another 75bps rate hike in November. We expect a deceleration in rate hike of 50bps in December as the Fed funds rate would already become very restrictive by then at 4.5%, warranting more cautious steps. As core CPI inflation proves to be stickier-than-expected, we have recently revised our scenario to add a final 50bps rate hike in February 2023, leading to a terminal rate of 5% (vs 4.5% previously). We then expect a pause in rate hike for the rest of 2023 and rate cuts in 2024.
Has a US recession scenario already priced in?
- We will not be surprised to see any bear market rally especially when “bad news” on US economic data could be “good news” for markets on expectations of a less aggressive Fed. However, despite significant selloff in risk assets this year, we still worry about further downside probably next year due to the following reasons:
- Risk assets tend to underperform in an environment of higher real yields and tightening financial conditions.
- The fast monetary tightening coupled with a strong USD and US Treasury yield curve inversion can provoke a credit event either domestically in the US or abroad.
- Extent of drawdown in the US equity market, PE multiples especially for the US big tech names, credit spreads and corporate earnings estimates are yet to adjust to historic recessionary levels.
- Despite the bearish investor sentiment, we have not seen significant outflows in US equity market year-to-date. In particular, the large cap growth stocks, which are still trading 3x above the average PE for the rest of the S&P 500, are vulnerable to a capitulation if investors unwind their years of passive inflows.
What are the investment solutions in face of a US recession?
Investors should stay defensive and diversified with a focus on quality and income. The significant re-pricing of rates means quality assets are now paying attractive yields. We upgraded US Treasuries and investment grade bonds from neutral to positive last month, with their yields now more attractive than their US equity counterparts for the first time since 2004 being part of the reasons. US Treasuries are also safe assets to hedge for a recession.
To navigate the continued market volatility, investors can consider to diversify their portfolios with:
- Developed markets government bonds and investment grade bonds
- Quality dividend stocks from the energy, financial, and telecom sectors
- Alternatives such as trend-following and global macro strategies in hedge funds which typically outperform during stagflation periods
- Structured products that allow limited downside while capturing the upside for multi-assets
- Private credit, private commercial REITs (from warehouses, self storage, data centres, student/apartment rental housing assets) and private infrastructure (energy, utilizes, telecoms, transport, renewables and social infrastructure) funds with defensive profiles and regular income distributions
Read Investment Navigator October 2022: Finding the Silver Linings in the Storm
