Since the start of Fed tightening in the first quarter of 2022, the most frequently asked question about the global economy has been whether the Federal Open Market Committee’s (FOMC) fight to tame inflation inevitably means the US economy is heading for recession. If the price of reigning in inflation is a recession, the follow-on question is, how deep and till when? And how do we think about financial market outcomes in such times?
As things stand today, US activity data is mixed. Retail sales and industrial production had contracted. Job data is mixed where nonfarm payroll continues to be positive, but job openings moderate and initial jobless claims moved up. Earnings outcomes for Q1 2023 have also been decent. Clearly, data doesn’t point to recession yet, but during inflationary periods, it is not unusual for employment downturns to begin months after the start of a recession. We saw this in the 1973 and 1980 recessions. Higher inflation leads to a delayed onset of profitability loss, which in turn delays the layoffs. Presently, corporate profit should act as a leading indicator of wage growth and inflation moderation.
Rates Hikes During Recession
Interestingly, the 1973 and 1980 recessions saw rate hikes (instead of a cut) as inflation was high and job market data was strong. While we do not call out for an exact repeat of those times, given that inflation, corporate profits and job market data rhyme closer to the decades of the 1970s-80s, the market continues to be surprised by Fed’s aggression.
Synchronised and aggressive rate hikes thus far make a case for deeper problems in the real economy, going ahead. Interest rate matters and there is a tremendous value in the yield curve which points to a strong probability of recession in the next 12 months.
Coming to the market, equity markets start to correct prior to the onset of recession and bottom out into the recession. During the 1973, 2001 and 2008 recessions, the S&P 500 fell ~50 percent. On other occasions, there has been ~20 percent corrections (1981, 1990 and 2020 recessions). As we speak (or write!), the S&P 500 has fallen 13 percent from its peak. Mapping the past today, we fear material growth slowdown in the US which will drive earnings correction.
The template for fixed income assets was quite different during the 1970s and 80s compared to the last three decades when duration assets performed at the mature stage of the rate hike cycle. The high inflationary periods of the 1970-80s were different though; the 10-year US Treasury rose into the 1973 and 1980 recession. That is perhaps explained by high inflation leading markets to doubt the longevity of rate cuts.
Taming Inflation Expectations
Mapping this history in the current context, sharp monetary tightening in the last one year should drive cyclical disinflation - though one could argue that a 2 percent inflation target is far-fetched. On top of that, issues around financial stability may provide some breather to rate hikes. But for a sustained bond market rally, it is imperative that Fed kills inflation expectations once and for all.
To sum up, 2022 was one of the worst years for stocks and bonds in the US. Into 2023, the global equity market prospects are still grim unless we see a significant dovish tilt by the Fed and greater clarity on the depth and breadth of the recession. The outlook for US duration assets is improving at the margin. That said, the longevity of the duration rally will be challenged unless inflation is brought under complete control. Similar story applies to India. FY24 earnings expectations could be tested depending on the global growth trajectory. While valuations have corrected, some downward adjustments may still be due.
We continue to think of 2023 as a year of adjustment in Indian equities even as longer-term trends favour an investment led earnings cycle in India. On the other hand, we are positive on Indian fixed income assets – gaining support from an end to monetary tightening, moderating inflation, reduced external account concerns, and an outlook for appreciation in rupee.
Namrata Mittal is Senior Economist, SBI Mutual Fund. Views are personal, and do not represent the stand of this publication.
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