The R word

Last month, I shared with you my expectations for the next three years and concluded that equity returns will most likely be acceptable, if not phenomenal. After publishing the November letter, I realised that I am up against a virtual tsunami of bears. I received a large number of reactions from readers, saying more or less the same thing. I shall spare you from all the colourful details; suffice to say that I was advised to find another job, if I cannot see recession written all over the wall in front of us.

Now, allow for a bit of self-defence. Firstly, when I talk about recession risk, unless otherwise stated, and I have made that point numerous times over the years, it is always a 12-month view. In other words, last month, when I predicted a soft landing but no recession in the US, the time horizon is 2024 and not any further. I am not nearly smart enough to predict what is going to happen 3-4 years from now.

Secondly, I should have said (but didn’t) that if the US is going to be hit by recession next year, it is not likely to be a particularly harsh one.  The last recession to hit the US (the Global Financial Crisis) was very dramatic, but most recessions are not. Most recessions are vanilla recessions, caused by rising unemployment and/or corporate inventory adjustments.

In vanilla recessions, the downside in equities is typically 15-25% as equities go off-risk.  However, what typically also happens in vanilla recessions is that equities rise by a fair bit more on the other side, as equities come back into favour again. Therefore, even if I were to build a recession into my 3-year outlook, my annualised 3-year return expectations wouldn’t change.

Thirdly, although I will argue this month that the most likely 2024-outcome is a soft landing, my forecast refers specifically to the US. I am of the opinion that the risk of recession in Europe is a fair bit higher than it is in the US, and that is particularly the case as far as the UK is concerned. Brexit has done immense damage to the UK economy, particularly to inflation, which has left it in a more vulnerable position than other major economies.

It is also worth mentioning that the impact of a UK recession on the global economy will most likely be negligible.  The same is certainly not true, should the US economy go into recession. Finally, I should also point out that Germany is probably already in recession which, to a significant degree, has been caused by its dependence on exports to China.

In this month’s Absolute Return Letter, I will build a bit further on last month’s letter. I will explain why I think a recession, if it were to happen, is likely to be relatively modest in size and thus do limited damage to both the economy and the stock market. Having said that, I should stress that a modest recession is not my base case. Modest, yet positive, economic growth – aka a soft landing – happens to be what I think is the most likely outcome of the present slowdown.

Recession or soft landing?

Let’s begin with some good news on inflation. Whilst rarely a problem unless the economy is firing on all cylinders, runaway inflation has indeed been a major challenge more recently. Three factors have accounted for the lion’s share of the inflation problem – energy prices, food prices and wages.

As is obvious when you look at Exhibit 1a, not only is the worst over as far as energy and food inflation is concerned, but both have begun to have a disinflationary impact on overall inflation. Now, neither food nor energy inflation is considered core inflation, and one could therefore argue that what should really worry us the most is high wage inflation. Having said that, as you can see in Exhibit 1b, wage inflation adjusted for productivity enhancement – aka unit labour costs – is dramatically lower than overall inflation levels. And the fact that unit labour costs are now growing only modestly faster than the inflation target will please the Federal Reserve Bank.

Speaking about the Fed, it has been criticized for not being aggressive enough when hiking; however, as you can see in Exhibit 2, apart from the one-man show in 1980 when Volcker took virtual control of the global economy and managed to destroy the inflation monster with a series of aggressive hikes, Powell and his colleagues have tightened more aggressively than in any other hiking cycle in the last 50 years.

I tend to agree with common wisdom on Wall Street that recessions are the product of Fed ‘policy errors’ – that they sit on their hands for too long and then, when they finally take action, they overreact and push the economy into recession. Europeans shouldn’t glee from schadenfreude, I might add. Our central bankers are no different.

In the context of recession vis-à-vis soft landing, the conclusion I draw from Exhibit 2 is that if the US economy can withstand the medicine provided by Powell & Co more recently, it is in too good a shape to go into recession anytime soon. One reason the US economy is doing relatively well at the moment is the savings ‘hangover’ from the COVID-19 pandemic (Exhibit 3) – the fact that many US households are still sitting on meaningful savings aggregated in the early stages of the pandemic. And, as we know, most Americans prefer to spend rather than save.

The very modest rise in US unemployment more recently is another reason to be relatively optimistic on economic growth in the US despite the aggressive hiking programme conducted by the Fed. I have never seen a recession emerge when labour conditions have been as robust as they currently are. That can obviously change but, for now, I do not expect the US economy to dip into a recession. The curved line in Exhibit 4 is consistent with a soft landing – not recession.

Adding it all up

One could argue that, effectively, it doesn’t matter much whether we end up with recession or a soft landing. Whether ΔGDP equals -0.5% or +0.5% year-on-year, the economy is indeed soft. It might not be collapsing as in 2008, but neither is the economy firing on all cylinders. The distinction is therefore more relevant to statisticians than to the man on the street, one might argue.

To some degree, that is indeed correct, but there is at least one meaningful difference.  If ΔGDP remains positive, the Fed will most likely stay passive. If ΔGDP dips below zero, the Fed will probably start to ease. One could therefore argue that a mild recession (with an emphasis on “mild”) is, in some ways, a better outcome than very modest, yet positive, economic growth – for investors but also for the man on the street. Equities will respond favourably to lower policy rates, mortgage costs will start to decline and so will the cost of credit card debt.

I should explain why our return expectations for the next three years are so modest, even if no recession materialises. As you can see in Exhibit 5 below (which I have copied and pasted from the November Absolute Return Letter), our base case return for global equities is only +4% annually - less than half of what you have earned annually over the last 30-35 years. I explained it in more detail in the November letter (which you can find here) but, in simple terms, it is a function of rich equity valuations at present.

Should we end up with a relatively mild recession, our return forecast for global equities (of which US equities account for 70%) drops to +2% annually (the negative case above). If the recession turns out to be more dramatic, our return forecast drops to 0% annually (the negative tail above). However, if you were to look at the next three years separately, our forecasts would vary a great deal from year to year, depending on the severity of the economic setback. Over a long life in finance, I have learnt that the most prosperous bull markets are almost always born from a starting point of extreme pessimism. Do I need to say more?

Niels C. Jensen

1 December 2023