About the author: Jake Jolly is head of investment analysis for the Global Economics and Investment Analysis team at BNY Mellon Investment Management.
There is a cruel irony that the most telegraphed recession in memory leaves the outlook in the coming quarters highly uncertain. Ongoing labor-market strength at the same time as regional banking sector turmoil seems to suggest the economy is simultaneously robust and teetering on the edge. Such an incongruous economic state, at the tail end of the most aggressive monetary hiking cycle in decades, will inevitably conclude with meaningful implications for investors’ portfolios.
So, how will the economy land? Three scenarios appear most likely. Each is differentiated by the impact of recent banking sector turmoil, the persistence of core inflation and tight labor markets, and what that implies for rates and asset prices.
Starting with the most optimistic scenario: Soft Landing (a 20% probability in my estimation). Here, hopes of “immaculate disinflation” become reality and the economy avoids a recession. This outcome requires a trifecta of, one, ongoing disinflation with limited hiccups (that is, inflation turns out not to be sticky), two, a benign normalization of the job market (job openings are substantially reduced without major job losses), and three, a Federal Reserve confident (and correct) that inflation is defeated in the near-term. Although a Soft Landing is possible, the odds are against it. It requires economic slack to be generated in a manner unlike in previous cycles. It would seem to require “this time is different” to hold, and that is a temptingly dangerous statement. Moreover, it would require banking sector concerns to fade relatively quickly with limited lasting impact via tightening credit conditions.
History suggests that a more probable scenario is a Credit Crunch (50% probability) that results in a typical monetary-policy-induced recession, possibly beginning in the second half of this year. This scenario envisions tighter lending conditions ahead that will do much of the work of additional Fed rate increases. Specifically, the Fed hikes again in May and then pauses, but the tightening already in the pipeline is sufficient to bring inflation back down. Bond markets have signalled elevated recession risk via inverted yield curves since mid-2022, but only recently are the real economic impacts being felt. Financial condition indexes and bank lending surveys suggest conditions are tightening and, in this scenario, they tighten significantly more. Ultimately, it is the aggregate, knock-on effect of the banking sector turmoil that delivers the economic slack needed to rein in inflation at interest rates near current levels. Inflation moves toward the Fed’s 2% target but weakening aggregate demand adversely impacts earnings and risk assets broadly.
Complicating matters, there is a third possible scenario worth considering, a Delayed Landing (30% probability). Essentially, this scenario is what analysts have taken to calling “no landing” in the near-term, but that is followed by a harder, later landing in 2024. In this scenario, banking concerns have a fleeting and smaller-than-expected impact on activity, but the Fed nevertheless pauses too soon, possibly because it overestimates banking issues’ impact on credit conditions. This allows inflation to re-accelerate on still- firm aggregate demand later in the year and forces the Fed to unexpectedly re-start the hiking cycle. Rates must go higher than the market expects, and this shock tightening causes a nastier recession, but not until 2024. This is the most challenging scenario, because it may appear for some time to be a Soft Landing, only later unmasked, and revealed to be a Delayed Landing in disguise.
Given this set of scenarios, my sense is that the near-term is foremost about preserving capital through managing exposure to assets with larger downside risk profiles and focusing on quality exposure across the portfolio. To this end, I favor high-quality fixed income as it provides an attractive risk-reward profile based on the scenarios above. Opportunities in fixed income are considerably better than in the recent past. The heavy lifting is behind us on interest rates, and the return of income today is the silver lining of last year’s historic bond market rout. Moreover, history suggests that in a recession, bonds are likely to outshine more economically growth-sensitive equities. And as we quickly near the peak policy rate, the slowdown playbook is quite clear, begin extending duration to “lock-in” intermediate yields and mitigate reinvestment risk.
Equities may be higher by the end of the year, but we expect sharp swings along the way as market sentiment whipsaws on conflicting data that may constrain equities in a no man’s land between scenarios for some time. Until economic data more convincingly points toward one of the landing scenarios, expect volatile range-bound trading to persist.
With hindsight, how the economy eventually lands will appear readily obvious. For now, it is anyone’s guess. As the saying goes, “failure to prepare is preparation for failure.”
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