An uneasy journey: from inflation to recession

We are now in the final months of an abysmal year for investors. Higher than expected inflation has persisted and worsened through the year, leading to volatile markets. Global and US stocks have lost almost 25% year-to-date, while European stocks declined by about 17%¹.

Central banks around the world have taken up the fight against inflation and are hiking rates, bringing the post-pandemic recovery to a halt. Inflation, of course, was not the only negative factor for markets, there is also the war in Ukraine and an energy crisis.

But now, there are signs that the market is less worried about inflation and is becoming more worried about recession. This is in line with our expectations for a mild recession in the US and a deeper recession in Europe.

_{1 As measured by the MSCI World, MSCI US and MSCI European indices, in local currencies, as of 18 October.}

This is not to say that inflation is now beaten. It is not. Risks remain, and we expect that both the US Federal Reserve and the European Central Bank (ECB) will continue to raise rates through the end of the year. But some positive signs in the inflation fight are evident and we believe inflation will come down significantly in the coming quarters. Housing prices, a key component in “shelter” inflation, for example, are declining. And the prices for certain goods in the US, such as used cars, clothing and medical goods, are falling, as demand for durable goods declines. US wage growth and job vacancies are also both decreasing, signalling some softening in the strong US labour market. Key inflation elements related to services, however, remain stubbornly high.

In contrast to consensus opinion, our forecast is for key US policy rates to top out at 4.5% by the end of December and for European rates to peak at 2%. We believe that at this point, the Fed and ECB will likely pause, as they reckon with the economic slowdowns their rate hikes have created. Thereafter, we expect US rate cuts of 100 basis points in the second half of 2023.

Another factor of concern has been the energy situation in Europe this winter. We now believe that Europe is as well prepared as possible for the winter heating season. Natural gas prices remain high, but are well off their peaks. A reduction in demand, growing use of renewables, a soft winter, long-term contracts and more supply could further ease energy prices. The European Commission has also announced plans to curb high natural gas prices in the near term.

Against this backdrop, the ABN AMRO Investment Committee decided to increase market exposure and to put some cash to work by investing in government bonds and equities. The overall asset allocation is now neutral for bonds (having increased from slightly underweight); the equity position remains underweight, but less so; and cash remains overweight.

This year, stocks have been under pressure from higher interest rates and, to a lesser extent, earnings adjustments. Our expectation that the Fed and ECB will stop hiking interest rates at the end of the year means that while rates will remain restrictive, a key headwind is easing. Rate cuts in the second half of the year could even prove supportive for equity markets.

By taking a first step now to reduce our underweight position, we are buying at a time when earnings have been revised downward, valuations have become more attractive and investor sentiment is extremely bearish. Fears for a recession are in our view justified, and the impact on earnings is not yet fully reflected in share prices. Therefore, we maintain a (smaller) underweight position.

Our regional and sector preferences have not changed. We continue to prefer the US market (small overweight) versus Europe (small underweight), with a neutral stance toward emerging markets. In terms of sectors, we favour health care and consumer staples, given their resilience and defensive characteristics.

The interplay between inflation and recession fears is also seen in bond markets. After rising relentlessly for months, yields showed their first weakness in early October, declining by 0.5% within days, until, even more quickly, they rose again to higher levels. (Bond yields and bond prices move in opposite directions.)

A peak in yields is always hard to pinpoint, but we believe that the October dip is an indication that we are approaching levels where recession risks are dominating inflation fears. To reach this tipping point, we need to see inflation peaking, which we expect in the next few months.

In this environment, safe government bonds yielding 2% or more have become increasingly attractive, based on their return, low risk and diversification benefits. They can also once again provide some portfolio protection in adverse circumstances.

Turning points are usually only seen in hindsight. Nonetheless, we believe that there are indications in both bond and equity markets that a turning point is on the horizon. Inflation is no longer the dominating issue it once was and the moment of peak interest rates is getting closer.

In this environment, rising bond yields, that we expect later to fall back, are an opportunity to lock-in above-cash returns. We also know that equity markets generally anticipate conditions by six to nine months. The anticipation of lower interest rates will provide some support, but we believe that the impact of the coming recession on earnings will probably outweigh this support. A defensive stance towards equities is therefore still the right approach.

By putting cash to work now, we are laying the groundwork to be more opportunistic later, when the US and eurozone economies turn from weakness to growth and emerge from recession.

Richard de Groot
Chair ABN AMRO Investment Committee