Thought Leadership

Market Report - Positioning beyond recession

What lies ahead for investors in late 2023 and beyond? We’ve assessed the market's response to the ever-changing economic landscape, reviewed market trends and analysed investment opportunities. We’re talking about economic resilience, interest rate dynamics, and diversification and durability…it’s not quite as bad as the headlines suggest as our year of inflections moves closer to the end and into a rather more optimistic 2024…

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In our last report, dated 30 June, we spoke about a divided Wall Street and City. There was concern whether, after a strong first half of the year, gains would continue, or the rally would be set to fizzle out in the second half of 2023. And so, continues our ‘year of inflections’.

Was this the calm before the storm or the end of the worst recession that never was?

The public views recessions as bleak economic times. In Barron's article, 'It's time to rethink the recession' Seema Shah states that “investors typically associate the concept with drastic and prolonged asset price falls. Yet, the US recession, forecast to start in mid-2024, will look and feel very different from recent recessions. Not only is it likely to be shorter, but it will also be of a much lesser magnitude. As a result, investors need to think beyond just preparing portfolios for recession. They need to consider positioning for investment opportunities that will drive markets into 2024.”

The US Federal Reserve has raised interest rates to 5.25% in February 2022 and kept them there ever since. Barron's points out that despite this, "incoming economic activity data remains resilient, consumer demand remains strong, and jobs growth has only just started to slow."

However, the economy can show strength now and still be heading for a recession. According to Barron’s monetary policy “often works with long and variable lags, and given how quickly interest rates have been increased, policy has only been restrictive for a reasonably short period. This suggests that the pressure on economic activity is just getting started.”

Barrons continues "With the Fed indicating interest rates will remain elevated for a prolonged period, a sustained monetary policy drag is likely to exacerbate already tightening credit conditions, undermining the health of the US economy."  In other words, the chart should look more like Table Mountain than the Matterhorn.

According to UBS, there are three narratives an investor would need to believe in for equities to rally further:

  1. The Fed will not increase rates
  2. The widely predicted US recession is no more
  3. The AI rally was justified

In the three months since writing this, inflation has receded, meaning the Fed and other major central banks are closer to the end of their tightening cycles. The US labour market has cooled, but not so much as to push the economy into a recession. In their 'thought of the day' of 15 September 2023, UBS stated that "earnings have improved, with US-listed company profit expectations now back at all-time highs." Yet global equities are down -6.6% (MSCI Global) over this period, and bond yields remain elevated.

According to UBS, “this creates an opportune moment for investors.”  Their CIO, Mark Haefele, continues to explain, in his article 'back in balance', that "Against a supportive backdrop for stocks and with bond yields high, we expect decent returns across asset classes: 8–10% for major global stock market benchmarks and 10–15% for major high-quality bond indexes in US dollars, sterling, Swiss franc, and euro by June 2024. And by diversifying, investors can also earn these returns while reducing exposure to potential risks.”

Haefele believes cash offers good current yields. But while “we expect bond and stock returns to prove durable, the high interest rates on cash today are likely to drop in the next 12 months. Taking a longer-term view, we expect cumulative cash returns of just 5–14% depending on currency over the next five years, versus cumulative returns of 15–25% in bonds, 40–55% in stocks, and 25–65% in alternatives, based on our Capital Market Assumptions.”

Reasons to be optimistic

While there are still reasons to be optimistic, we might not see their impact until late in 2023 or possibly even 2024.

  • Economic recovery: The US economy has surprised us with its resilience. The labour market remains strong and continues to support robust household consumption, particularly on services.
  • Corporate earnings: The Q2 earnings season exceeded forecasts thanks to upside surprises in top-line sales and profit margins. S&P 500 profits fell by -5.8% year-over-year in Q2, against initial expectations of -9.0%. Revenues rose +1.0% from the previous year, against consensus expectations of no growth, and margins contracted by -0.9%, against forecasts of -1.4%.
  • Central banks close to the end of their rate hike cycles: The latest ‘dot plot’ of policymakers’ interest rate expectations, published in September, showed that the US central bank expected to raise rates one more time to between 5.5% and 5.75% by the end of 2023 and cut rates twice in 2024.
  • Inflation falling: US inflation is decelerating faster than expected and the balance between labour supply and demand is progressively becoming less inflationary, even if it still has a long way to go.

Reasons to be cautious

  • Economic downturn: An exogenous shock is also possible. Disappointing growth in China has raised concerns about possible spill over effects into the global economy. However, even for a trade-oriented region like the Eurozone, China accounts for only around 8% of exports; for the US, that figure is 7.5%.
  • Oil price: The rise in oil prices in recent weeks (33% since June) will lead to higher headline inflation, and being a highly visible price to consumers, may undo some of the progress made in reducing inflation expectations.
  • Inflation: Inflation is still above official targets, and rising oil prices threaten to keep it elevated over a longer period. It is unclear if or when the interest rate hikes that central banks have enacted will begin to have a larger effect. China’s economy has disappointed.
  • US interest rates: The Federal Reserve will next determine short-term interest rates on 1st November. Fed Chair Jerome Powell has made it clear “that decisions will depend on the data.”  The Fed may therefore increase rates if upcoming data shows that inflation is not slowing as fast as the Fed would like.
  • US ‘shutdown’: The start of a new federal fiscal year in October challenges the US Congress to avoid a government shutdown. But, according to UBS "unlike the recent debt ceiling debate, which posed an existential threat to financial markets, the risk of long-term adverse consequences from a temporary closure of US government offices is minimal."

Market expectations for a ‘Goldilocks’ scenario that would support global markets until the end of July were probably too good to be true. To some extent, August’s volatility highlighted that a growing number of investors seem to share the same concern.

China’s problems could also have a knock-on effect to the global economy, particularly within their heavily indebted property sector.  In the meantime, as inflation is coming down, there are still risks to assess and so we expect the central banks to maintain their current restrictive positioning for the rest of the year and possibly beyond.  In order to combat these risks, we continue to be minded that investors should keep a broad mix of assets within their portfolios.

So, can we expect more turbulence in the coming months?

According to UBS the macro backdrop suggests a “combination of higher growth and lower inflation than had seemed possible a few months ago. The Fed now faces less pressure to hike rates further, and rising real wages are reducing the economic pain from earlier rate hikes.  The macroeconomic backdrop has improved, and there is an increasing likelihood of a ‘softish’ landing being achieved. But both equities and bonds have been broadly range-bound for the past three months. We think this creates an opportunity for investors, and we expect positive returns across both markets over the next six to 12 months.”


The Fed’s policy remains data dependent, but one more rate hike?

At the start of August, the credit rating agency Fitch downgraded the US government’s credit rating from AAA to AA+, citing unsustainable debt and deficit trajectories, and increased political dysfunction. While this decision led to heated debates in political and economic circles it had little impact on 10-year US Treasury yields, which hardly increased after Fitch’s announcement. However, yields rose later in the month on the back of better-than-expected economic data and strong issuance.

Overall, incoming economic data remained solid in the US. Labour market data pointed to a cooling but still strong jobs market in July, with payroll job gains of 187,000, slightly below consensus expectations for 200,000. Unemployment ticked down to 3.5%, while average hourly earnings were slightly stronger than expected at 4.4% year-on-year (Y/Y). Retail sales increased 0.7% month on month (M/M) in July, well above expectations of a 0.4% M/M rise.

On the inflation front, the headline Consumer Price Index (CPI) increased slightly in July to 3.2% Y/Y due to higher food and energy prices, while core CPI decelerated slightly to 4.7% Y/Y from 4.8% Y/Y in June. Iza Wealth's August market report states that "the minutes of the Federal Reserve (Fed)’s July meeting nevertheless revealed that most officials remain concerned about inflation, and thus left the door open for additional rate hikes if necessary. Jerome Powell’s Jackson Hole speech, unlike last year, has been well received by financial markets. Overall, the Fed’s policy will remain data dependent with a bias to tighten if necessary."

According to Iza Wealth market pricing suggests “the Fed could deliver one final hike before year-end, followed by four or five rate cuts in 2024. The August purchasing managers’ indices (PMIs) certainly supported this dovish outlook, as the manufacturing and services PMIs fell to 47 and 51, respectively.”


Recession coming?

Eurostat’s flash gross domestic product (GDP) estimate showed that euro area GDP grew by 0.3% quarter on quarter (Q/Q) in Q2 2023. While this pace was relatively modest, euro area labour markets remain very tight, with the unemployment rate dropping to 6.4% in June, its lowest level on record. However, the economic outlook remains uncertain, as the August composite PMI fell to 47, its lowest level (ex-COVID-19) since 2012.

Eurozone headline inflation defied expectations and remained flat in August at 5.3% Y/Y. Core inflation, however, did fall modestly from 5.5% Y/Y in July to 5.3% Y/Y in August. While improving, inflation nevertheless remains well above the European Central Bank (ECB)’s target and markets continue to price further ECB rate increases before the end of the year.

The MSCI Europe ex-UK index dropped by 2.2% in August, dragged down by the banking sector after the Italian government announced a tax on banks’ ‘excess’ profits. European bond yields remained broadly stable in August and the Bloomberg Euro Aggregate rose 0.3% over the month.


So far, the UK has avoided a technical recession

The Bank of England (BoE) hiked its policy rate by 25bps at the start of August, bringing the Bank Rate to 5.25%. The BoE highlighted its intention to hold rates at restrictive levels for some time. Despite this tighter monetary policy, the UK economy surprised to the upside during the second quarter of 2023, as GDP rose by 0.2% Q/Q versus a consensus expectation of 0.0% Q/Q. UK headline CPI eased in line with expectations to 6.8% Y/Y in July, down from 7.9% Y/Y in June. Labour market data showed growth in regular pay (excluding bonuses) was 7.8% Y/Y in the period April to June 2023, the highest rate since comparable records began in 2001. In this context, markets continue to expect further rate increases from the BoE this year.


China’s reopening momentum is stalling… unlike Japan, where inflation is appearing for the first time in a generation…

In China, activity data was much weaker than expected. On the inflation front, CPI turned negative in July at -0.3% Y/Y. Meanwhile, producer price index (PPI) deflation continued for the 10th month in a row. Retail sales missed expectations by a wide margin, growing 2.5% Y/Y against expectations of 4.5% Y/Y. A rebound in the coming months seems unlikely as household confidence also remained weak.

Chinese investment data also highlighted low business confidence as private investment decreased 2.3% Y/Y in July. Real estate was the weakest sector, with an 8.5% fall in investment between January and July compared with the same period last year. The difficulties of Country Garden and Evergrande, two of China’s largest property developers, also highlighted real estate weakness in August.

To address these difficulties, as well as deflationary risks, the People’s Bank of China (PBoC) lowered its interest rate twice in August, but so far credit demand remains weak. At the end of August, Beijing also took several initiatives to support financial markets, such as halving the stamp duty on stock trading. Despite these measures, the Renminbi lost 1.6% against the US dollar over the month, while the CSI 300 index dropped 6.2%.

In Japan, the economy expanded by 6.0% Q/Q in the second quarter of 2023 on the back of a strong contribution from net trade. Activity indicators, such as the Tankan index, point to a continuation of this strong momentum in the coming months. Japan also seems to be turning the page on its deflationary period, with core CPI up 10 bps to 4.3% Y/Y in July and spring wage negotiations, known as ‘shunto’, leading to the biggest wage increases in 30 years. Compared to other markets, Japanese equities proved relatively resilient in August as the TOPIX posted a modest gain of 0.41%.

How have the markets performed?

We have selected key indices as a representation of the markets rather than a substitute for the whole market as they are the most recognisable for our clients.

US Treasury yields rose to new cycle highs in September. This was due to a combination of positive macroeconomic signals and higher oil prices, suggesting that to bring inflation under control the Federal Reserve will have to keep interest rates higher for longer. The move to higher yields was exacerbated by massive Treasury selling by China and Japan, concerns about the US budget deficit and fiscal sustainability, and the removal of a large buyer through Quantitative Tightening.

These concerns were compounded by Chair Powell’s hawkish comments and uncertainty about the future path of the US economy following the Federal Open Market Committee’s (FOMC) decision to keep rates on hold on 20 September.

Both 2 and 10-year US Treasury yields recently reached their highest levels since 2007 at 5.2% and 4.9%, respectively. The 10-year real yields have surged to 2.3%, their highest since 2008.

The S&P 500 Index suffered four consecutive weekly declines in September. Growth stocks and stocks with higher valuations underperformed the wider market, with the technology sector among the weakest performers. After reaching its lowest level since the 2020 pandemic, equity market volatility has increased strongly.

With bond and stock markets falling simultaneously in Q3, commodities have been the notable outperformer, echoing the market dynamics of 2022.

Interest Rates in 2023

All the major central banks now have a mandate to ensure that interest rates rise and fall within what are considered stable inflationary limits.

In most instances, this is 2% per annum, the 'goldilocks' scenario whereby the underlying economy is neither 'too hot nor too cold'.

NB: The figures below in the final column are an amalgam from several different sources, so are more akin to a trend rather than a prediction.  They are for the full cycle rather than a fixed period.

On 20 September, the Federal Reserve left interest rates unchanged between 5.25% and 5.5%. Chair Powell stated that officials are “prepared to raise rates further if appropriate, and we intend to hold policy at a restrictive level until we’re confident that inflation is moving down sustainably toward our objective.” Other Federal Reserve officials have reiterated that the central bank must leave borrowing costs higher for longer.

The updated ‘dot plot’ of policymakers’ interest rate projections showed that they still expect one more rate hike in 2023, but that they expect to cut rates only twice in 2024, down from four times in the June ‘dot plot’.

On the positive side:

  • The median GDP growth forecast has been doubled from +1.0% to +2.1% for2023 and increased from +1.1% to +1.5% for 2024;
  • The unemployment rate is expected to rise to 3.8% in 2023 and 4.1% in 2024, down from projections of 4.1% and 4.5%, respectively, in June;
  • ·And the Core PCE inflation forecast was lowered from 3.9% to 3.7% for2023 and remained unchanged at 2.6% for 2024.

Chair Powell repeated that the Federal Reserve was guided by “incoming data” rather than by “estimates of equilibrium real interest rates or any model.” Assuming inflation continues to soften as expected, this suggests that monetary policy is tight enough and there might be room to lower nominal rates more in order to stabilise real rates in 2024, particularly as the labour market supply/demand imbalance is becoming less inflationary.

Which asset classes should we consider?

Mark Haefele, Chief Investment Officer at UBS, recently wrote about a question he frequently gets from clients in the current interest rate environment: “Why invest at all?" He goes on to explain that "even if the macro backdrop is decent, overall risks are lower, and the base-case outlook for markets is favourable, why take any downside or mark-to-market risk, when the returns available on cash look good?"

His short answer is durability. “While returns from stocks and bonds may be uncertain over the short term, we expect them to prove durable over the long term. By contrast, cash may pay a certain and high return in the near term, but today’s high interest rates are likely to drop in 12 months, presenting reinvestment risk.”

Overall, again according to our friends at UBS, they expect “cumulative cash returns of just 5–14% over the next five years, versus cumulative returns of 15–25% from high grade bonds, 40–55% from global stocks, and 25–65% from alternatives, based on their Capital Market Assumptions. In addition, investors often underestimate how well a combination of stocks, bonds, and alternatives can reduce the volatility inherent in holding any of those asset classes individually. For example, in our downside scenario, global stocks would fall by 17%, but 10-year US Treasury bonds would rally by 21%. Equally, in our upside scenario of positive growth surprises, bond markets might return a modest 7% compared with equities’ 17–19%."

“Last year’s simultaneous annual losses for equities and bonds were unusual; since 1926, this has only occurred three times. But if it were to occur again, we think a healthy allocation to alternatives can mitigate portfolio downside: In 2022, diversified alternatives indexes delivered performance between –6% and +17%.”

UBS's Haefele states that, "We believe that having a well-diversified portfolio, across all asset classes, reduces risks, decreases volatility, and allows for a smoother performance over time.  In other words, diversification is about a trade-off between potentially short term higher gains and a more predictable long term growth."


According to the OECD the world economy is expected to grow by 3.0% in 2023 before slowing down to 2.70% in 2024, of which most of this comes from Asia despite the woes in China.

Headline inflation is coming down, but core inflation is still persistent and remains above central bank targets, hence the 'higher for longer' mantra from the Fed.

Our year of inflections is coming to an end, and we finish more optimistically than we started.  There could still be some volatility in the markets in the coming weeks but given the experiences investors have faced over the last 3-4 years, from Covid and beyond, we can at last look to the horizon and lift our eyes to a future, notwithstanding the shorter term risks, that does look at little rosier than before.

Mark Estcourt


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