Why is the risk of a recession still high?
Analysis by Philipp Bärtschi, CFA, Chief Investment Officer at J. Safra Sarasin on the global market environment with insight into the outlook for bonds, equities and asset allocation with recession risk remaining high
After an encouraging start to the year, financial market sentiment has deteriorated slightly recently. This is due on the one hand to very solid data on the labor market and retail sales, but above all to a smaller than expected decline in inflation rates in the US and Europe, which has convinced market participants that the interest rates would have risen more sharply and for a longer period than previously anticipated. The entire US yield curve has seen an increase in yields and, as one would expect in these cases, increased more at the short end than at the long end. Fed funds futures are now signaling a US terminal rate above 5.6% at its peak versus below 5.0% at the start of the year. A rate cut of 50 basis points for the second half of the year has almost completely disappeared from market expectations.
The possibility of further tightening of monetary policy forces market participants to pay close attention to inflation and short-term economic developments. Looking into the second half of the year, investors should keep in mind that a slowdown in economic growth seems almost inevitable. As soon as the rate hikes have exhausted their restrictive effect, it is probable that private consumption will decrease significantly both in the United States and in the Eurozone.
Meanwhile, the economic situation in China is getting better and better. The end of the zero-COVID policy will not only have a positive impact on the Chinese economy, but also, in particular, on those regions that are economically highly exposed to China. While market participants initially seemed to have underestimated this development, forecasts for China's economic growth have now been revised upwards. The latest China Purchasing Managers Index recorded a further increase for the services sector in February, reaching 56.3 points, after a 12.8-point increase in the previous month. The manufacturing index also rose for the second consecutive month, reaching a 10-year high of 52.6 points. The data confirms a solid recovery, already seen in other data on economic activity.
Bonds – Rising rates put pressure on the asset class
After a brief period of relative calm, bond market volatility has picked up again and the shape of the yield curve has changed significantly. In the US and Europe, the short-term portion has risen to levels not seen since the global financial crisis. As longer-term yields have shifted less, the curve is now more inverted than it has been in the last forty years. The rises in interest rates in recent weeks are in particular due to the increase in inflation expectations. In any case, the risk that inflation will not fall to central banks' 2% target as quickly as expected, but will remain elevated for longer, has recently increased significantly. Inflation-linked bonds offer effective protection against this scenario.
At the same time, heightened uncertainty has not led to a significant widening of credit spreads. This market situation makes positioning very challenging both in terms of maturities and credit quality. High yield bonds remain vulnerable to corrections due to low risk premiums despite high interest rates. Investment-grade bonds perform more robustly in an environment of macroeconomic uncertainty.
Equities – Relatively unattractive at the current level
The sharp increase in equity valuations at the start of the year weighs heavily on the overall attractiveness of the asset class. US earnings yields are lower than government bond yields, a situation not seen since 2007. At the same time, downside risks to earnings remain amid significant growth uncertainty and the likelihood of upside of interest rates. This is also indicated by a disappointing quarterly earnings season for the fourth quarter of 2022. Against this backdrop, analyst earnings estimates have gradually fallen towards our expectations in recent weeks.
In China, on the other hand, the positive developments following the end of the zero-Covid policy continue strongly and beyond investors' expectations. This is cause for optimism going forward and opens up the possibility of positive surprises for Chinese and emerging market equities, while it appears to be limited for US equities, particularly at the current level.
Asset Allocation – Recession risk remains high
While the economic backdrop is solid and recent data has been better than expected, the risk of a US recession over the next 12 months remains elevated. Against this backdrop, bonds generally appear more attractive than equities. We therefore maintain our underweight in equities, but have reduced it slightly due to better macro data and the high degree of forecast uncertainty. We remain overweight emerging market equities, which are likely to have a positive surprise.
Bonds could come under further pressure as inflation expectations rise. However, at the current level of interest rates, well over 4% in dollar terms, high quality US bonds with short maturities are attractively valued. High yield bonds have become less attractive due to the recent spread tightening. However, the high carry is beneficial and therefore we are only slightly underweight. The outlook for emerging market bonds, on the other hand, is brighter in the medium term. The positive growth differential of the economies of emerging regions and the easing of inflationary pressure argue in favor of this asset class.
We are slightly overweight in alternative investments. We believe cat bonds are extremely attractive given the current level of yield. We remain overweight in commodities. The expected decarbonisation of the global economy will lead to high demand for strategic resources in the medium term, so we are at the beginning of a new super cycle. Furthermore, the acceleration of growth in China should lead to an increase in the cyclical demand for raw materials.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/perche-il-rischio-di-recessione-rimane-elevato/ on Sun, 19 Mar 2023 06:29:40 +0000.