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Market Volatility
Jared Franz
Chris Buchbinder
Pramod Atluri
What happened to the widely predicted recession that was supposed to wreak havoc on the US economy this year? It happened. Just not all at once.
Different sectors of the economy have experienced downturns at different times. Thanks to this rare case of a “rolling” recession, the US may not experience a traditional recession at all this year, or next, even with the dual pressures of elevated inflation and high interest rates.
“I am increasingly seeing signs that we may not get a broad-based recession,” says Capital Group economist Jared Franz. “Instead, what we are getting are mini-recessions in various industries at various times without much synchronisation.”
Different sectors have experienced downturns at different times
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Sources: Travel: Capital Group, Transportation Security Agency (TSA), U.S. Department of Homeland Security. Data is a 30-day moving average. As of 26 July 2023. Semiconductors: Capital Group, Philadelphia Stock Exchange, Refinitiv Datastream. As of 30 June, 2023. Data represents cumulative price return since 1 January, 2019. Housing: Capital Group, Refinitiv Datastream, Standard & Poor's. Latest available monthly data is May 2023, as of 27 July, 2023. Manufacturing: Capital Group, Institute for Supply Management (ISM), National Bureau of Economic Research. Refinitiv Datastream. Figures reflect the seasonally adjusted survey results from ISM's Manufacturing Purchasing Managers’ Index (PMI). A PMI reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally declining. As of 30 June, 2023. Chemicals: Capital Group, U.S. Federal Reserve, Refinitiv Datastream. Data indexed to 100 in 2017. Figures are seasonally adjusted. As of 30 June, 2023. Oil: Capital Group, Refinitiv. As of 26 July,2023. Past results are not predictive of results in future periods.
Residential housing, for instance, contracted sharply last year after the US Federal Reserve started aggressively raising interest rates. At one point in 2022, existing home sales tumbled nearly 40%.
“Now it looks like the housing market is starting to recover while other areas of the economy, such as commercial real estate, are beginning to spiral down,” Franz explains. “As more people work from home, the outlook for office real estate is particularly troublesome.”
Likewise, the semiconductor industry was plagued by broken supply chains and lower demand for computer chips in 2022. That sent semiconductor stocks plummeting. This year, the business has stabilised, demand has returned, and semiconductor stocks are driving a rally in the global equity markets.
Can a full-blown recession be avoided?
If these contractions and recoveries continue, Franz explains, we could wind up in an environment where US gross domestic product does not turn negative at any point in 2023 or 2024, thus averting one of the most widely predicted recessions in history.
“I still think a short, mild downturn is possible,” Franz says. “But if consumer spending doesn’t crack, then this widely expected recession could be like the boogey man who frightened everyone but never showed up.”
Indeed, the federal government recently reported that the US economy grew at an annual rate of 2.4% in the second quarter. That was well above consensus estimates and faster than the 2% rate in the first quarter. The surprisingly strong growth was driven by stable consumer spending and dramatically higher business investment, up 7.7% on an annual basis.
Consumer and business strength has also contributed to a red-hot labour market, with healthy job creation and an unemployment rate of 3.6%, near a 50-year low. “Recessions are nearly always associated with broad-based job losses,” Franz notes, “and we just aren’t seeing that right now.”
US economy is bolstered by historically strong job market
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Sources: Capital Group, Bureau of Labor Statistics, Refinitiv Datastream, U.S. Department of Labor. Figures are seasonally adjusted. As of 30 June, 2023.
What about the inverted yield curve?
On the other side of the recession debate, many economists have argued that an inverted yield curve is the most reliable recession predictor that we have. Right now, the inverted yield curve — which happens when the yield on short-term bonds is higher than the yield on long-term bonds — appears to be screaming for a recession. And it has been for more than a year.
An inverted yield curve has preceded every US recession over the past 50 years. The current yield environment is more inverted than it has been since the early 1980s. This powerful signal has convinced many economists and bond market investors that a recession is inevitable in the next year or two.
Could that view be wrong? Or at least a misreading of the bond market? Yes, says Pramod Atluri, fixed income portfolio manager.
High inflation, which we also have not seen since the 1980s, is the key determining factor today, Atluri believes. Fed officials have made it clear that fighting inflation is their priority, and they appear to be achieving their goal of bringing prices back down to earth. Inflation fell to 3% in June from 9.1% a year ago, a remarkable decline in just 12 months.
That means Fed officials may be able to cut interest rates in the months ahead, not because they expect a recession, but because they are close to achieving their stated goal of 2% inflation.
Is an inverted yield curve no longer a reliable predictor of recessions?
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Sources: Capital Group, Bloomberg Index Services Ltd., National Bureau of Economic Research, Refinitiv Datastream. As of July 26, 2023.
“An inverted yield curve means the market is predicting that the federal funds rate will be higher today and lower tomorrow. That’s it,” Atluri adds. “The yield curve is not predicting an impending recession. It is predicting that inflation will be lower in the future and, therefore, the Fed will be able to end its rate-hiking cycle.”
“As a corollary, if inflation gets back to 2%, then an inverted yield curve will once again be a good predictor of declining economic growth and rising recession risk,” Atluri concludes.
What are the investment implications of a soft landing?
Many investors have clearly been positioning their portfolios for a recession, as evidenced by a massive rotation into cash and cash equivalents over the past two years. As of 30 June assets held in such conservative investments surpassed $5.4 trillion, according to the Investment Company Institute.
But what if a recession is replaced by a soft landing? What opportunities does that present to investors who are willing to venture out a bit on the risk spectrum?
“Earlier this year, I was very concerned about a recession,” says Chris Buchbinder, an equity portfolio manager. “But I have eased off that expectation and, in my view, I’d say the probability now is below 50%.”
That view has led Buchbinder to consider investing in companies that are traditionally impacted by recession worries but have proven to be resilient — particularly in the post-pandemic recovery period. Pent-up demand has benefited many companies in the travel and leisure industry, for instance, as well as aerospace and aviation.
Semiconductors, chemicals and oil are also interesting, he says, given their recent difficulties and growing signs of a turnaround.
Travel & leisure activities rise while commercial real estate sinks
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Sources: Capital Group, Standard & Poor's, Refinitiv Datastream. A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. As of July 25, 2023. Past results are not predictive of results in future periods.
“This has been Godot’s recession; we’ve all been waiting for it,” Buchbinder says. “But because of that fear, many companies started pulling back in anticipation of a downturn. The Fed started raising rates. And now there are fewer imbalances in the economy. So there are fewer things that can go wrong from here.”
“In this environment,” he added, “I am increasingly focused on industries that are discounting some additional economic weakness that may never show up.”
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