Do not believe in immaculate tightening
That is now largely the consensus view in the market, but recession has not arrived yet and bulls are starting to get excited that perhaps it will not after all.
The debate is not just the likelihood of recession, but whether it is credible that monetary policy could tighten so much without negative ramifications for the economy.
A relief rally, triggered by an expectation that China’s ‘reopening trade’ could reignite growth, has therefore been a feature of markets so far in 2023.
It remains our view that a recession is highly probable.
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Economies take at least 12-24 months to digest interest rate hikes, economies are yet to feel the full force of the tightening that has been done, let alone any further hikes that we may see.
One obvious example is mortgage rates; many homeowners on fixed term mortgages still have their monthly repayments reflecting the old rock-bottom rates, but as more of those deals roll over, the pain in the housing market will grow acute and that will feed through into other parts of the economy.
This dynamic is especially acute given the fact that consumers around the world have already been doing their best to navigate the cost of living crisis.
The somewhat more optimistic market narrative year to date does not do much to dissuade us from our central thesis.
One can always quibble about the timing of when a given economy might enter into technical recession, but broadly speaking we expect to see broader evidence of economic strain visible in the macro data from Q2/Q3 this year onwards.
We remain particularly concerned about a deterioration of the US labour market, noting that temporary workers are already in decline and layoffs amongst professional services such as financials and technology companies have been firmly on the rise.
From a market perspective, we may also see some more volatility surrounding regarding the US debt ceiling.
Because the federal government cannot issue debt at the moment it has to draw upon its cash at the Federal Reserve, and that injects stimulus into the markets and wider economy on a temporary basis which has gone a long way to offset the impact of quantitative tightening.
When a deal on the debt ceiling gets done (which should be at the latest by early June) that process will likely reverse, sucking liquidity out of markets.
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That, in combination with continued quantitative tightening, may prompt a further bout of risk asset volatility.
When it comes down to it, though, let us not forget that we have had a massive rate hiking cycle accompanied by quantitative tightening.
In our mind it is unrealistic to expect that such major monetary tightening could happen without negative ramifications on the economy, and any theory that growth can keep going regardless – what we are calling ‘the immaculate tightening cycle’ – just does not seem credible to us.
Of course, the global economy is a highly complex machine, and there are offsetting factors (such as China’s ‘reopening trade’) that could at the margin delay the onset, or moderate the severity, of the recession at the edges.
But we remain convinced that, unfortunately, recession is coming and unemployment will rise.
Look out for downward revisions to old unemployment data (the US Bureau of Labour Statistics have already done so for Q2 2022) as evidence of that trend feeding through.
As bond investors, the good news for us is that tougher economic times should be accompanied by interest rate cuts, and that is a good environment for fixed income markets.
Harry Richards investment manager at Jupiter Strategic and Dynamic Bond funds
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