Macquarie’s economic update Part 2 – In the US, winter is coming
In their latest global economic update, Macquarie Bank economists, Ric Deverell and Hayden Skilling, paint a far from rosy picture of the year ahead. For the US they see rising interest rates, a slowing economy and a strong chance of a recession. And their views on returns in equity markets are bleak. If they are correct, then it’s time for investors to be extra cautious, and to focus their portfolios on quality and growth.
US yields have been a major focus for investors recently with the spreads between two and ten-year yields inverting. Deverell and Skilling asked, how much higher could the 10-year go? Suggesting nominal 10 year yields to increase from here if inflation expectations remain elevated following the pattern of 2013.
The Fed is most concerned about high short-term inflation expectations leaching into currently low long-term inflation expectations.
Overall Macquarie’s economists expect US yields to push higher over 2022; however, the yield on 10-year bonds is already two standard deviations above the 42-year downtrend driven by structural factors, suggesting some resistance. We have written about those structural factors extensively here at the blog and in particular note the rise of automation and the decline of union membership both put a lid on long-term wages growth, and by extension, inflation.
Will the US economy will slow?
Meanwhile, risks are building that the US economy will slow considerably in 2023. The stronger services consumption in 2022 will likely fade in 2023. This explains why the bond market is pricing in some risk of a recession in 2023. But with the US Fed Funds rate remaining near the lowest level in history, considerable work by the Fed is yet to be done.
As we have noted in earlier blog posts, Jerome Powell has simply asked the market to trust him when it comes to engineering an economic soft landing. His confidence comes from three previous episodes since the 1980s when rates were increased rapidly and significantly and a hard landing was avoided. “Trust us” seems to be the mantra. With the yield curve beginning to invert, however, Macquarie reckons a soft landing is possible but will be hard to achieve.
Indeed, Deverell and Skilling believe, with the US economy overheating, the Fed is behind the curve, which amounts to a major policy mistake.
Also, overheating economies normally precede a recession. Recessions are frequently engineered by central banks. The US is overheating now, and the Fed will need to jump on it. It will be very hard to pull off a soft landing and, while Macquarie said the US has never really done it, Jerome Powell cited three examples in recent history during his speech to the National Association of Business Economists.
US unemployment is much lower than the natural rate and it is still going down. Monetary policy meanwhile is nowhere near neutral and miles away from restrictive. The Fed, according to Macquarie will need to play catch up and monetary policy is a very blunt instrument.
If inflation is 4% in a year, will the Fed keep hiking?
In another bearish assessment, Deverell and Skilling put the probability of perfectly landing at an almost zero chance. The big question for Macquarie’s economists is this: if inflation is four per cent in a year, will the Fed keep hiking? The Fed will not want a decade of stagflation like the 70s. It took a decade to sort out. So it must be preferable to go hard and sort it out now, even if it means a recession. A recession is just two-quarters of negative growth. Thus, assuming only two quarters, a recession would be a much better outcome than stagflation.
The US consumer is reasonably resilient but US consumer sentiment is souring. Nevertheless amid inflation and rising rates, Deverell and Skilling believe the consumer should be pretty resilient. Those on low incomes don’t own a house nor are planning to buy and so should not be impacted by rising rates. If consumer sentiment becomes very weak and deteriorates, Deverell and Skilling can see some pullback in spending. But while jobs look good, it will be sentiment that drives the outcome.
The outlook for equity returns
As for equities, Deverell and Skilling also believe achieving high equity market returns is harder from here. Equity returns are lower in an environment of rising rates, inflation and a shrinking Fed balance sheet. Of course, investing in high PE tech stocks at any time will secure lower returns – remember the higher the price you pay, the lower your return.
Deverell and Skilling believe global growth will remain resilient in the near term, even though yields have moved higher. Equities should do ok for the rest of the year but the challenge is that equities move with the near-term cycle and very clearly, growth has peaked. Consequently, things will get harder as the year goes on and investors should expect volatility.
Deverell and Skilling believe we might have entered one of those unusual cycles where equities rollover ahead of the economy. Their best guess is equities being slightly higher at the end of the year, but they expect it will be very hard for the Fed to land this and the risk of recession in US next year very high. In a rather alarming assessment, they believe there is a reasonable possibility of a 30-50 per cent correction in equities in 12-18 months’ time and associated with a recession in the second half of 2023.
Part of their reasoning is big commodity shocks historically have been followed by recession.
This time, however, the picture is somewhat complicated when China is thrown into the mix. Chinese growth has slowed due to COVID and it is adding fuel to supply chain pressures. The positive, however, is China targeting 5.5 per cent growth, which will require massive stimulus to achieve.
Risk assets could do well while the US remains resilient and China stimulates.
Next in this series will be Macquarie’s outlook for Australian equities, commodities and the economy.
Read part one here: Macquarie’s economic update part 1 – Inflation, war and COVID
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
