US recession now likely within 12 months

Given stubbornly high U.S. inflation and the Federal Reserve’s apparent determination to bring it down, I now foresee a U.S. recession within the next 12 months.

Specifically, I anticipate the U.S. National Bureau of Economic Research (NBER) will at some stage between now and end-2023 declare that a US recession began between June 2022 and June 2023. Indeed, U.S. econonomic growth was negative in the March quarter and there is now a reasonable chance that June quarter economic growth will be negative also, reflecting weakness in business investment and consumer spending. Indeed, the “GDP Now” forecast by the Atlanta Federal Reserve now estimates 0% growth for the June quarter.

What does this mean for markets? As evidence of a U.S. economic slowdown emerges, I anticipate bond markets will at least stop raising the expected peak of the Fed funds rate in this tightening cycle (currently around 4%). The same is true for the RBA.

Indeed, I suspect we are likely close to the worst in terms of global and Australian bond market performance.

For equity markets, however, the outlook is less comforting.

The average bear market decline during a U.S. recession is around 35%, with the declines during the Global Financial Crisis and Dotcom Crash in 2008 and 2001 respectively closer to 50%. At 17, the S&P 500 price-to-forward earnings ratio is still above its long-run average (of around 15 to 16), and a decline closer to previous recession lows of 10 to 14 seems likely as fear overtakes greed among investors. What’s more, analysts still anticipate around 10% earnings growth in 2022 and 2023 – negative growth in either or both years now seems more likely.

Accordingly, Wall Street does not yet seem priced for recession, and there seems scope for equity markets to fall further. My base case is the ultimate peak-to-trough decline in the S&P 500 will be 35%, implying a decline to 3,100 from its closing peak of 4,796 on 3 January.

For investors, periods of U.S. recession and associated bear markets can be difficult periods to endure. But the lesson of history is that markets do eventually bounce back. The Fed seems determined to learn the lessons of history and does not want to let supply side shocks and overly strong demand embed high inflation (and so also high interest rates) into the U.S. economy to the same degree evident in the 1970s.

Good buying opportunities will emerge in this period, especially in the now downtrodden growth/technology sectors which still offer strong long-term earnings potential and will benefit from an eventual return to lower inflation and steadier interest rates. And while value stocks (especially energy and resources) – could continue to do well in this high inflation environment, they will ultimately be vulnerable to a weakening in inflation and commodity prices as global growth slows.

And while it may seem like “catching a falling knife”, long duration fixed-rate bonds are also starting to offer value. Indeed, for the first time in a long time, investors now have an opportunity to lock in attractive long-term income returns in relative defensive fixed-income assets.

As for Australia, as the saying goes, when the U.S. sneezes we catch cold. The local share market will not be immune to further Wall Street weakness, especially as we also face uncomfortably high inflation and likely aggressive RBA rates hikes in coming months. Consumer sentiment has already tumbled and house prices are starting to weaken. 

While I am still hopeful the Australian economy can avoid recession, it is at least a 40% risk in the coming 12 months. Either way, our sharemarket will likely follow the US into bear market territory, with at least a 20% peak-to-trough decline likely in coming months – that implies a decline in the S&P/ASX 200 to at least 6,000 (from a recent peak of 7,592 on 21 April).

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