Hello again. We’ve been fully engaged in our re-branding to Columbia Threadneeedle – a huge undertaking – but we’re largely done so these weekly macro videos are back.
I’m afraid I don’t have much good news to report in terms of the near-term outlook. Interest rates are headed higher and we’re on a clear course to recession in the US and Europe.
The reasons for recession do vary though. In the US, domestic demand pressures are so strong that the Federal Reserve (Fed)will have to engineer a recession to get inflation back down to target. Inflation is strong and accelerating in two key areas: rents and wages. These persistent sources of inflation can only be tackled by weakening the economy. Last week’s purchasing managers’ index slumped into contractionary territory in the US and there are already signs that the US labour market is slowing: initial unemployment claims have been edging higher for weeks. But that easing is coming off super strong levels.
What is needed, to halt inflation, is a significant rise in unemployment. Given that background, the Fed will deliver another 75 bps rate hike, with the promise of more to come. The market thinks we are close to the end of the hiking cycle and are actually pricing in rate cuts in 2023. I reckon rates will have to rise further than the markets expect but the truth is nobody knows for sure – and that includes the Fed who have dismally failed to accurately gauge the path of inflation so far in this cycle.
Same problems but causes differ in Europe
The reasons for recession are rather different in Europe. Yes, headline inflation has risen rapidly and unexpectedly this year, as in the US, but domestic sources of inflation are less strong in Europe. In the Euro area, wage inflation is more muted and still broadly in line with the ECB’s 2% inflation target. And many companies are making one-off payments to workers – payments that will be easier to reduce next year when conditions are likely to be much tougher.
Recession in Europe is much more related to the cost-of-living crisis, notably around gas prices. The scale of the price rises is breathtaking. Looking at the futures market for gas, for the coming winter, prices are 8 or 9 times higher than pre-covid levels. That’s a staggering rise. To put this into context, if oil had experienced the same rise, we’d be looking at prices of $500-600 a barrel.
This is all linked to Putin and gas from Russia, of course. The UK gets little of its gas from Russia so is less exposed to risks of a supply cut off. But it pays roughly the same price for gas. Consumers here and in the rest of Europe face a huge rise in their energy bills this winter.
A bumpy road ahead for equities
So what does all this mean for markets? First of all, there’s the obvious point that recessions are bad for equities. In all recessions since the war, US equities have fallen for several months after recession has begun. And it hasn’t begun yet. The good news from the medium-term perspective is that equities have always rallied months before recession end. Moreover, the sharp fall in equities so far this year has occurred against a background of strong earnings, so valuations have improved significantly. I also reckon that the US recession will be brief: once unemployment starts to rise, US wage inflation will quickly ease. That’s the lesson from previous US recessions.
Resilience in modern economies
Remember that modern economies have shown a great ability to adjust and, looking further out, equities are still likely to offer superior, if more volatile returns. Yes, the immediate future looks tough but the longer-term case for risk assets remains.
