Our views and positioning across our portfolios haven’t changed since our June commentary “Where Do We Go From Here.”
Most advanced economies have so far dodged the recessions that we, and many others, had expected to start towards the end of the first half of this year. The relative resilience of activity can be pinned on several supply and demand-side supports to growth, as well as the fact that the full effect of monetary tightening is taking its time to feed through. However, as the various tailwinds fade and interest rate hikes bite in developed economies, and as the re-opening recovery fizzles out in China, the resilience of global activity in early 2023 is unlikely to last. We are forecasting mild recessions in the coming quarters in major developed markets, which should help push down on underlying inflation. That said, we expect it will take a year or more for core inflation rates to close in on the central banks’ 2.0% target.
"We are forecasting mild recessions in the coming quarters in major developed markets, which should help push down on underlying inflation."
We still see the U.S. sliding into recession late this year. Strong jobs growth and core inflation will keep the U.S. Federal Reserve (Fed) in a hawkish mood for now but as the economy weakens and the downward trend in core inflation gathers pace, we believe interest rates will eventually be cut more quickly than markets are now anticipating.
Although the euro-zone recession will persist, we expect underlying price pressures to be slower to recede than in the U.S., owning to the earlier rise in U.S. core inflation and the consequent quicker shift to tightening by the Fed. Accordingly, the European Central Bank will keep interest rates at their peak until well into next year.
The Bank of Canada delivered another 25bp hike in July to take the overnight rate to 5.00%. The Bank cited evidence that core inflation is proving more persistent to justify the hike. With the labour market loosening, core inflation falling and the survey indicators implying that inflation expectations are normalizing, we expect the Bank’s next move to be a rate cut, albeit not until 2024.
Strong immigration and the turnaround in the housing market have reduced the risk of recession but, with the Bank of Canada back in hiking mode, we still judge that GDP will contract later this year. Even if a recession is avoided, a sustained period of below-potential GDP growth and a rise in unemployment will ease inflationary pressures. The key issue remains that households are heavily indebted and the relatively short maturity of most mortgages means the debt service ratio will continue to rise sharply.
“Extremely strong immigration will probably prevent consumption from falling outright, but we still expect growth to slow to a crawl as higher borrowing costs bite and the unemployment rate rises toward 6.0%.”
Extremely strong immigration will probably prevent consumption from falling outright, but we still expect growth to slow to a crawl as higher borrowing costs bite and the unemployment rate rises toward 6.0%. The big risk is that the mild recession that we expect will not be enough to get inflation back to 2.0% on a sustained basis. While immigration will eventually help to pull down wage growth, for now, it is contributing to upward pressure on rents and house prices. If those components of the CPI remain higher than we forecast, the Bank might have to engineer a deeper economic downturn to pull inflation down to a level consistent with overall CPI inflation of 2.0%.
Implications for Financial Markets
We continue to expect risky assets to struggle over the second half of this year, as major developed market (“DM”) economies slip into recessions and the souring risk appetite to turn financial markets back from the current enthusiasm. For further emphasis: equities have nearly always fared poorly when the economy has turned down. Since 1855, there have been 34 recessions in the U.S. and the stock market has declined around the majority of them. When markets did not decline during recessions, this phenomenon tended to occur either when i) a bubble was forming in equities; or ii) the valuation of the stock market was already depressed after the end of a war (when military spending subsequently declined), or a period of high inflation. Markets typically peaked before a recession began, and troughed shortly before it ended.
“Meanwhile, we think DM government bonds will rally, partly due to safe-haven demand and partly because we suspect that investors are underestimating how quickly and deeply central banks will cut rates….”
It’s also conceivable that some of the recent euphoria around artificial intelligence (“AI”) gets unwound if the recession calls into question the strength of analysts’ expectations for future earnings. Meanwhile, we think DM government bonds will rally, partly due to safe-haven demand and partly because we suspect that investors are underestimating how quickly and deeply central banks will cut rates (even if those rate cuts won’t actually come, in our view, until next year). But, we anticipate that risky assets’ struggles will be short-lived. By 2024, we expect the global economy to be on the mend and we think enthusiasm about AI technology, which has been a tailwind for the stock market this year, will provide a further boost to U.S. equities, although a sustained outperformance will rely on a broadening the rally.
As I wrote in June, the outperformance of U.S. equities this year is owed entirely to a handful of stocks benefiting from the enthusiasm around AI. Outside of the U.S., we still expect decent returns from most other DM equity markets, although the absence of major technology firms in other markets is likely to lag behind the S&P 500. Stock selection will be more important in those other markets as they will likely not benefit as much, at least not initially from the AI tailwind. Emerging market (EM) equities have typically outperformed their developed market counterparts after U.S. recessions. We believe that EMs could provide some solid returns as well. While we don’t foresee them replicating the sort of outperformance seen after the early 1990s or early 2000s recessions, we do think the MSCI Emerging Markets Index will provide better returns than the MSCI World Index over the next few years, in contrast to much of the past decade.
In summary, our views have not changed over the past month nor has our asset allocation. We are maintaining our slight bias to defensiveness, and we stand ready to make changes to our positioning, to become more aggressive, as our thesis plays out.
Chief Investment Officer
IPC Portfolio Services