Will the Fed tighten the U.S. into recession?
by Todd JablonskiMr. Jablonski is CIO, asset allocation, for Principal Asset Management. Visit www.principalam.com.
Heading into 2022, investors were optimistic that as effects of the pandemic began to fade, supply chains would begin to normalize, and inflation pressures would start to ease. 2022 began with what was a resilient growth backdrop that was quickly upstaged by geopolitical disruption and central bank policy upheaval. Throughout the year, investors have had to analytically navigate the volatile market and now, the work continues.
Currently, a synchronized global economic downturn is underway. The implications for investors have not been this pressing in over a decade. The global economy has been hit by several headwinds, almost all of them leading back to higher inflation that is expected to decline at a painfully slow pace.
Although global inflation has likely peaked, price pressures are proving very broad-based and sticky, particularly in the United States. Deliberate central bank action to create labor market slack and weaken demand is needed to lower inflation. As such, global central bank tightening will need to go further, and this will not only be one of the most aggressive global tightening episodes in history, but also the first economic downturn in many decades where central banks continue tightening into a recession.
With that tightening, the U.S. dollar continues to grow strong, piling on an additional challenge for global markets. Federal Reserve policy rates are set to hit 4.75%–5% in 2023 and stay at that level for most of the year, putting upward pressure on the greenback.
So Where Do Investors Go From Here?
Although multi-asset investors have been on standby for a recession throughout the past year, we know that historically, rapid tightening of U.S. monetary conditions has led to below average market performance. We expect a U.S. recession in Q2 2023, and it is now time for investors to play defense.
How To Navigate Recessionary Pressures
Looking ahead to 2023, investors will be faced with the challenge to navigate recessionary pressures. Multi-asset investors should prioritize reducing their exposure to vulnerable segments of the market, focusing on lower volatility, high quality assets, and seeking out the areas that can continue delivering stable earnings as growth weakens and monetary conditions become tighter— all while maintaining ample liquidity.
In this low growth, high inflationary environment, equity and fixed income classes will be challenged. Within equities, investors should focus on exposure to quality – inclusive of segments of the market which benefit from low growth and the strong U.S. dollar. Specifically, U.S. mid-caps may outperform given more attractive valuations and greater domestic revenue exposure. In terms of styles, value may continue to outperform until economic growth starts to deteriorate sharply.
This year has seen multiple bear market rallies, and as is typical during bear market rallies, weakening fundamentals have prevailed, causing equity markets to continue to slide. In total, tighter financial conditions have impacted global equity markets and valuations have cheapened. The economic backdrop points to earnings weakness ahead and, despite the recent rally, expectations of Fed tightening and weakening economic growth will likely cause further decline. Markets have faced up to the reality of central bank tightening, but now also need to adjust to a slowing earnings profile.
On the fixed income side, investors should seek safety and high quality. Rising recession risk could put downward pressure on long-term U.S. Treasury yields and perhaps spur spread widening, thereby taking the shine off short duration, low quality assets. The sector can now be looked at as a way to gain a positive income stream as bond yields have soared to their highest levels since before the Global Financial Crisis as markets re-priced Fed expectations. Preferred securities are our favored asset within fixed income and are in a more favorable spot of price, yield and quality. In addition, hiding places within fixed income such as U.S. Treasury and securitized debt may provide refuge amid increased economic risk.
Time To Get Real
Challenged equity and fixed income markets create a positive backdrop for real assets. The diversification benefits of real assets in this macro environment are particularly valuable, as are their fundamental strengths and defensive characteristics. Within real assets, infrastructure and commodities are two areas that are set to perform well.
Infrastructure investments typically shine during high inflation and are one of the few asset classes that may outperform in the current slowing growth, high inflation environment. These investments generally have predictable cash flows associated with the long-lived assets, with historically attractive yield. They also offer exposure to the global theme of decarbonization, which will likely outlast Fed tightening and recession concerns and presents a multi-decade tailwind for utilities and renewable infrastructure companies.
While inflation has prompted both stocks and bonds to experience historic drawdowns during 2022, commodities have rallied sharply. Since the start of 2022 through the end of Q3 natural gas was up 81%, brent crude up 26%, and iron-ore up 11%. The commodity complex, especially energy, has been the stand-out strategy to mitigate inflation. Recently, however, global economic strength has faded rapidly, driving markets to become increasingly fearful of recession, resulting in lower commodity prices. This pain should only be temporary. We maintain an overweight preference to commodities, as medium/long-term structural supply shortages should continue to support performance.
Consider The Risks
Against the backdrop of high inflation and rising rates, there are areas of less optimism and potential risks to consider.
The rising real rate environment is particularly difficult for REITs, given it is a very rate sensitive sector, and implies REITs may struggle. With central banks continuing to tighten policy, and inflation easing over the coming months as growth deteriorates, real yields are likely to rise further. REITs will come under further pressure, exacerbated by the incremental weakness in the housing market.
Investors should also consider the potential risks of a liquidity crisis and stubborn inflation requiring extended hiking cycles and high policy rates.
As central bank rates rise and the U.S. dollar continues to strengthen, liquidity shortages may abound. A market dysfunction, if large enough, could drastically change the outlook, with central banks needing to balance a sudden need for short-term liquidity against an immediate need to tame inflation. If higher wage growth becomes entrenched, the Fed may need to extend their hiking cycle and raise rates even beyond the anticipated 5%. This attempt to deliberately shock the economy into an extended recession would raise unemployment several percentage points, risking a sustained and structural hit to the labor market, not to mention a very prolonged and difficult period of low market returns and high volatility.
It’s clear that these are tumultuous times and there will be lasting implications not only for investors, but also for central banks in the future. Investors can still find opportunities in a challenge market like this one, but doing so requires an active approach.