Inflation to recession redux

• Recession continues to be expected
• Corporate earnings likely to deteriorate further
• High-quality bonds remain attractive
• US consumer spending and job growth are unsustainable

We began this year with an Investment Outlook entitled From Inflation to Recession. It was our expectation that high inflation, which had persisted for longer than the central banks expected, would eventually be contained by the rapid cycle of rate hikes and monetary policy tightening. And further, that policymaker actions would lead to a considerable economic slowdown. This was (and remains) the base-case economic scenario underlying our investment strategy.

Europe is now in a mild recession and further weakness is expected. Early in the year, we feared a deeper European recession. But there was a more positive-than-expected outcome to the European energy situation, which along with a mild winter, resulted in energy costs remaining manageable. And, in the US, the economy has so far withstood the impact of the Federal Reserve’s rate hikes. The US labour market remains strong and the economy and consumer spending have been boosted by government support.

The global economy is now in a better position than we expected six months ago. Nonetheless, we believe that the US economy cannot avoid further deterioration. The consequences of the Fed raising interest rates by around 5% in a one-year period is not likely to be avoided. Most of the increase in interest rates happened at the end of last year; and there is typically a four to six quarter lag before the effects are fully felt. We therefore continue to expect that the US economy will falter in the second half of the year and for a recession to begin in the US in the fourth quarter.

The inflation fight itself is going well enough, but it is not over. Core inflation (not including energy or food) is still high. We expect that the Fed and the European Central Bank will each hike interest rates just one more time in this rate cycle. They will not declare success after that, but, more likely, leave the door open to further hikes. Their goal is to bring inflation down to targets of around 2%, and we think it will take about 18 months to get there.

Given our expectation for a deteriorating economic environment that will result in both an economic recession and an earnings recession, the ABN AMRO Investment Committee is maintaining its underweight equity position and neutral stance toward bonds. Within the fixed income portfolio, two small changes were made. One was to lengthen the duration among high-quality European government bonds and the second was to reduce risk by replacing hybrid (subordinated) corporate bonds with “normal” corporate bonds.

Earnings growth has been slowing since the first quarter. Given our outlook for recession, we expect a sharp deterioration in earnings momentum. One of the first signs will likely be less positive corporate outlooks published around second-quarter results. Problems in China could further weigh on European company earnings.

We see no recovery in earnings in the second half of the year. Within a recessionary environment, no matter how mild, this is unlikely. We therefore expect an earnings contraction of 10-20% on a year-on-year basis.

Based on what we see as stabilisation by the Federal Reserve and the possibility of stimulus from Chinese policymakers, we are retaining our bias for emerging markets over developed markets. Given our outlook for recession, we are retaining our somewhat defensive sector positioning, with a preference for the health care sector, which can weather almost any economic environment given continuing demand, although it has suffered so far in 2023. We are also overweight the growth-oriented IT sector, which has been the top-performing sector year-to-date.

Bond yields continue to be torn between the fear of “sticky” inflation that pushes yields up and fear of recession, that pushes yields down. (Bond yields move in the opposite direction of bond prices.) We therefore continue to take a neutral stance to bond markets overall, with a preference for high-quality government bonds and investment-grade corporates.

Within the fixed-income portfolio, the decision was made to increase the duration of high-quality bonds by selling a portion of one-to-ten year French government bonds and to use the proceeds to buy Dutch government bonds (all maturities.) Increasing bond duration (sensitivity to interest rates) generally means that as interest rates fall, a bond’s price will rise (and vice versa).

The risk of the bond portfolio was reduced by selling the position in hybrid corporate bonds, which have characteristics related to both equities and bonds, and investing the proceeds in high-quality corporate bonds.

Given that the US economy has persistently defied recession expectations, it is reasonable to ask whether there will really be a recession at all. We believe there will be, because the drivers that have driven recent resilience (strength in consumer credit and job growth) are unsustainable.

We expect that the effect of higher interest rates will cool consumer spending over the coming months. And as consumer demand slows and ultimately declines, employment growth will also suffer. This is what is needed for inflation to be finally brought under control. We believe that the slowdown in employment will quash consumer spending, hurt corporate earnings and lead to recession. We expect the US Federal Reserve to back off from its monetary policy tightening in the first quarter of 2024, when we expect an interest rate cut.

Our asset allocation (underweight stocks and neutral bonds) is aligned with our outlook, while we also continue to seek opportunities where possible, such as in the IT sector and high-quality bonds.

Richard de Groot
Chair, ABN AMRO Investment Committee