This article was originally published on Northern Trust by Katie Nixon
Our base case remains slower but positive economic growth, which we foresee as stronger in the U.S. but still positive in Europe. We remain optimistic, but also circumspect as our attention is solidly focused on the many risks to our expectations — risks which are all to the downside.
We anticipate global core inflation hitting its peak soon — with energy prices remaining volatile and an upside risk to headline inflation given the prolonged war in Ukraine. We anticipate an aggressive Federal Reserve, as well as other global central banks, focusing on tightening financial conditions amid uncomfortably high inflation. This is very much already priced into capital markets. We view corporate fundamentals as solid, with healthy balance sheets and cash flows that provide ample interest expense coverage. And we see the U.S. consumer remaining quite healthy, supported by a robust labor market and growing labor income. Last, this outlook will manifest in mid-single digit earnings growth, which will ultimately support equities. This base case lays out a constructive case for risk-taking, although certainly suggests volatility will persist.
Growth could disappoint. Inflation could persist. Corporate earnings expectations may be too high. So, what is the downside scenario, and what does this mean for investors? In short, what if our base case is wrong?
1) Have we already slipped into recession?
The third revision to first-quarter U.S. gross domestic product pointed to a marginally deeper contraction in the January to March period. The revised -1.6% GDP print reinforced the bear case that macro conditions were already quite weak. What’s more, various recent Federal Reserve branch surveys including Dallas, Richmond and Philadelphia pointed to continued weakness. The recent Institute for Supply Management’s manufacturing index missed expectations, dropping to 53, the slowest pace since June 2020, from 56.1 in May.
The momentum is clearly slowing and a recession is not impossible. The consumption pivot from goods to services was also well foreshadowed, so this information from the manufacturing front is really no surprise, particularly given recent comments by large U.S. retailers indicating high levels of inventory and slowing demand. Acknowledging the recent string of weaker data, we would still emphasize that ISM observations above 50 still indicate expansion.
2) What if we are headed for a recession?
If the U.S. economy does see a second consecutive quarter of negative GDP growth, the official definition of a recession, we believe it would be shallow. We would anticipate less lasting damage, and we don’t see the kinds of systemic imbalances that turn recessions into financial crises. It is worth noting that recessions are more common than most realize, and that the U.S. has had 14 recessions since the Great Depression. Implicit in that observation is that along with recessions we experience economic recoveries. On average, excluding the COVID-19 recession, U.S. recessions last 10 months and real GDP declines roughly 2%. Our recession would probably look more like a garden-variety income statement recession and not the deeper and more damaging style of balance sheet recession that has followed large asset bubbles and suppresses consumer and corporate spending on a large scale.
3) What if we are overestimating the health of the U.S. consumer?
Consumption drives about 70% of the U.S. economy, so a healthy consumer is critical to economic growth. A vulnerable consumer means a vulnerable economy, and as we look across the U.S. economic landscape searching for signs of fragility, we must focus on the U.S. consumer. If jobs remain plentiful, and the labor market healthy, the U.S. consumer will continue to support growth. The labor market holds the key and is one of the most important areas of focus for us. Outside of the 2020 pandemic-led recession when the unemployment rate shot to nearly 15%, we can see from past recessions unemployment rising to 6-10% at recessionary troughs. That would represent a doubling of today’s 3.6% rate.
There does remain the possibility that the pernicious impact of inflation, which has increased more than wages, may drive consumer “demand destruction” as household income is increasingly absorbed by “needs” leaving little for “wants.” This is one risk. We see that the overall household savings rate has fallen significantly, and this presents an additional risk. And last, we are starting to see some fraying around the labor market edges, with hiring freezes and even layoffs visible in some industries. This bears watching.
We continue to see high levels of job openings, and although conditions have eased somewhat, we observe companies continuing to find it difficult to fill open positions. Wages have increased, and average hourly earnings have risen, particularly for the lower-wage worker. This is all supportive to consumer spending. Our premise remains that U.S. households are in good shape, and well-supported by an extremely healthy labor market.
4) What if inflation remains problematic?
This is certainly possible, although not probable. While it is far too early to give the all-clear signal, we are already seeing signs of inflation peaking or even falling in some areas.
If uncomfortably high price increases persist, this would drive an even more aggressive monetary-policy response. In that scenario, we would anticipate that the economy would be pushed into recession, financial conditions would tighten even further and more abruptly, and we would see a steeper drawdown in risk assets including equities. We would anticipate that the U.S. Treasury yield curve would invert, with long rates falling as shorter-term rates rise, and a “stagflationary” environment.
For investors, stagflation is a very difficult environment as corporate earnings face the one-two punch of lower demand and higher costs. Defensive stocks and companies delivering essential services tend to perform better on a relative basis, and real assets such as natural resources, real estate and infrastructure can offer some safe harbor. We hold real-asset exposure as a core element in strategic diversified risk-asset portfolios.
5) What if corporate earnings estimates are way too high?
This may be more of a probability than a possibility, and our own assumptions are already below Wall Street consensus. We still assume that most of the equity downside this year has been on the valuation front as investors have driven down the price-to-earnings ratio of equities in an environment of higher interest rates. Higher rates equal higher discounted cash flow, which equals lower net present value. It is simply market math.
That said, significantly slower earnings growth, let alone an earnings recession, is not priced into equities today. We can see this starkly displayed as companies that have provided negative guidance recently have seen stocks fall sharply, showing us clearly that the disappointment is not fully priced in. If the economy is slowing more than consensus estimates, and if corporate earnings growth disappoints, we can look to history as a guide. If we consider this period to resemble the 2001 recessionary period, or a cyclical bear market, we note that S&P 500 earnings declined a total of nearly 15% throughout that recession.
That magnitude of earnings degradation would doubtless drive further losses in equity prices. Equity returns during cyclical bear markets — those driven by economic cycles and not structural imbalances or exogeneous events — declined on average 30%. The S&P has fallen over 20% this year, reflecting a correction but not yet a cyclical bear market. If there is a silver lining in the cyclical bear market scenario, it is that the market has recovered and returned to peak levels on average in 12 months.