One of the most consensual views recently had been that the US (and perhaps Europe) would enter recession at some point in 2023. Europe likely sooner, given the ongoing drag from high natural gas prices, and the US later once the impact of US Federal Reserve interest rate rises started to bite. Surveys showed economists forecasting sharp slowdowns – consensus estimates were for a trough in growth in the second quarter. Critically, bond yield curves were inverted, which has historically been a robust indicator of recession (see Exhibit 1).
That consensus view has started to weaken. The clearest counter-argument has been the rally in risk assets so far this year: Global equities were up by nearly 8% by 1 February, while high-yield bond spreads have contracted by 50 basis points. Did the yield curve send a false alarm? Perhaps.
Our macro research team does still anticipate a recession in the US. Their view is that inflation, particularly wage growth, is more persistent than markets currently expect, meaning that the Federal Reserve will need to keep its policy rates higher for longer and induce a sharp slowdown in growth to reduce price pressures (i.e., the Phillips curve is flat).
Recession or not?
The scenario in which recession either does not materialise or is mild assumes that the encouraging trends recently seen in inflation persist. Monthly core goods inflation has been negative for several months and rent of shelter should fall as high mortgage rates dampen housing market activity. Wage growth indicators have improved, notably the latest average hourly earnings data and employment cost index.
If these patterns hold, the Fed could be able to cut policy rates by the end of summer, or so the market expects. The inverted yield curve then simply reflects that pattern, but a recession is avoided because inflation ultimately does turn out to be transitory. The cause of the inflation was extraordinary (lockdowns, then pandemic stimulus and finally reopenings), and its dissipation is also likely to be unconventional.
The fly in the soft-landing ointment is the state of the US labour market. The unemployment rate has been at 3.5% (and falling) when a rate at above 4% is historically needed to see wage growth consistent with the Fed’s 2% core inflation target. The number of job openings has remained high, suggesting there is far more demand for labour than supply.
While employment has returned to pre-pandemic levels, it is below where it likely would have been had the pandemic not occurred, and lower participation rates means there are fewer people to take the available jobs (see Exhibit 2).
It is hardly helpful when central bankers say their policy decisions are ‘data dependent’, but under the circumstances, it is understandable.
The Fed recently decided to raise rates by another 25bp. Its message – that rates will stay higher for longer and that a bigger slowdown in economic growth is needed – is premised on the view that wage inflation persists and goods prices do not continue to decelerate as quickly.
However, after the latest policy decision, Fed Chair Jerome Powell said that if inflation does continue to fall sharply, the central bank would cut rates in response. We will all need to wait and see if inflation recedes as hoped before knowing whether the yield curve signal was a false alarm.
US GDP growth beat expectations in the fourth quarter, and not surprisingly earnings from the latest reporting season have also so far come in above analysts’ forecasts. Worries that profit warnings and negative guidance would lead to a market downturn have been disappointed: most CEOs are still foreseeing solid demand. Personal consumption expenditures rose by 5% in the quarter (in nominal terms, annualised). It is only once demand begins to weaken that downgrades will likely follow.
In any case, analysts have already sharply revised down their expectations for near-term earnings growth for US companies. At the end of September, forecasts were for year-on-year earnings growth in the first half of the year of 7%. It is now -1%, in line with consensus expectations of economic growth troughing in the second quarter.
By the end of the year, however, earnings growth is forecast at an optimistic 11%. Equity markets naturally look through near-term drags; evidently, they are focusing on the potential boost to growth from China’s reopening and anticipating a looser Fed policy.
As always, the key judgment for equity investors is whether earnings growth estimates are realistic. Given the negative revisions we have had, they are now far more so than they were several months ago. Even if real US growth is negative in the second and third quarters, in nominal terms the economy is still set to expand over the course of the year, as are earnings (see Exhibit 3).
The Fed’s own predicted rate path would likely lead to a sharply lower level of GDP, in which case earnings estimates will need to drop further.