Yield curve signals investors to brace for recession in 2023
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Inflation, more pernicious and persistent than originally expected, remains the biggest obstacle to growth as economies around the globe slide closer to recession, says Lenny McLoughlin, senior investment strategist with Irish Life Investment Managers.
McLoughlin said he expects inflation to peak in the coming months and finally begin to moderate late this year and into next year. But he expects further tightening by central banks to continue to take a toll on equities, potentially leading to recession in 2023.
He pointed out that 10-year U.S. treasury bill yields dipped below the two-year yield in April — a historically strong indication of pending recession.
“When that’s happened in the past, going all the way back to the 1970s, on average 18 months after that inversion we’ve had a recession in the States,” he said. “So, while the markets are currently discounting slower growth, they’re beginning to discount the increasing likelihood of recession at some point in 2023.”
The most notable thing about 2022 so far, he said, is the huge change in the fundamental backdrop and concerted policy approaches to steer the economy.
“We’ve seen a war in Europe, we’ve seen inflation at the highest levels in 40 years, and we’ve seen the biggest policy shift from central banks in a number of cycles,” he said. “That has completely changed the outlook and the picture, compared to what we in the market were thinking at the beginning of this year.”
The downgrade from economic slowdown to likely recession is prompted by protracted geo-political concerns — from wartime supply chain issues to lingering Covid effects. Above all, monetary policy from central banks around the globe have tightened dramatically to fight inflation.
“In terms of the global growth outlook, it has obviously deteriorated this year,” he said. “We’ve seen growth forecasts for the global economy coming down from about 4.2% to just under 3% currently.”
McLoughlin added that business sentiment surveys and consumer confidence gauges are hitting lows not seen in 30 years in regions like the U.S. and U.K.
“With the likelihood of further tightening of policy coming through from central banks, given their determination to control inflation, we are likely to see slower growth as we go through the second half of this year and into next year,” he said. “In term of the possibility of a recession, I do think it’s increasing. When you see some of the data points coming through, they are disappointing. It does increase the possibility of recession happening in the second half of next year.”
He expects to see inflation peak in the coming months and begin to moderate as we move into the second half of the year and into 2023.
A big challenge remaining will be the weakened labour force.
“Labour markets have become very tight,” he said. “Demographic factors are at play here. We’ve seen slowing population growth, and aging populations. Participation rates in the labour markets have fallen and are below where they were pre-Covid.”
Other factors in the tightening of labour markets include diminished migration flows during Covid, reduced appetite for traditional jobs post-Covid, and the ongoing process of reshoring manufacturing plants which in recent decades had been moved to low-cost countries. A few years of dramatic supply chain bottlenecks convinced many companies to bring their manufacturing home, leading to an increased need for workers in an already tight market.
McLoughlin said the economic challenges of 2022 are reflected in the declines to equity markets year-to-date.
“The tighter policy that we’ve seen from central banks has caused bond yields to rise, and with that the relative attractiveness of equities versus bonds has been significantly reduced, and equities are no longer cheap versus bonds, which has put pressure on equity markets over the course of this year,” he said.
“In terms of where equity markets go from here, a lot has been discounted in the market at this stage. If you look at valuations, P-E multiples have fallen to 13.5 times against a long-term average of 16. And, again, when we look at what markets have done in previous large drawdowns within equity markets, that P-E multiple has often troughed somewhere in the region of 13. So, on that basis, it is suggesting that there is still some downside in markets perhaps, but it is relatively modest at this stage.”
He suggested equity markets won’t find the floor until central banks are done tightening the monetary supply, and fears of economic spiralling abate.
As for bond markets, he said risks are “probably slightly to the upside” given that inflation remains high.
“While the Fed is indicating that it’s going to continue to raise rates in coming months and quarters, we believe that they could actually need to go beyond 4% in terms of where the Fed funds rate eventually settles and peaks out at,” he said. “Historically, when you look at where the 10-year yield in the States peaks through the cycle, it typically peaks close to the peak in the Fed funds rate. And given that the Fed is currently suggesting that that will peak around 4% and possibly even higher, it suggests to us that there is still some upside in bond yields from current levels.”
He acknowledges the bulk of the move in bond yields may already be in but “we don’t think we’ve actually hit the highs yet.
“We do believe that there is still further upside in bond yields from these levels,” he said.
This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.
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