US Recession? The end of the debate is near

The Federal Reserve started lifting the Federal Funds Rate in March last year and, incredible but true, 14 months later the global financial world is still debating whether the US economy will experience negative economic growth, when exactly, or not at all.

Whatever the actual outcome, and irrespective of when exactly this question will have an answer, the long-winded, elongated trajectory of the current inflation-targeting process must have many an investor tuned out by now.

There's only so much attention that can be focused on an event that has the financial world both worried and heavily divided.

Unfortunately, the definitive answer to that one crucial question comes with serious ramifications, either way, for equities and other risk assets across the globe. Probably no surprise thus, market trading volumes have thinned considerably and most indices are simply moving side-ways inside a lower volatility trading range.

We'd all like to know the answer and move on, but that's not how it works. Plus, there are now a few additional question marks to blur the outlook, including:

• the US debt ceiling,
• the US banking sector,
• China's uneven recovery, 
• the RBA and the domestic mortgage cliff, and 
• the ongoing war in Ukraine.

One major change that occurred recently, and which could potentially mark an important turnaround pivot in a year-long negative trend, is forecasts for US corporate profits are no longer declining.

Break in trend for US profits?

Market forecasts in the US have been on a declining trend for approximately 12 months, but March-quarterly results released over the past weeks have broken the negative trend. The all-important question is now: what does this mean, exactly?

If you're bearish still, it's simply a pause. Economic indicators are pointing towards decelerating momentum into the months ahead. Inflation is falling, but still high. Corporate margins remain near an all-time record high. Once falling revenues combine with downward pressure on margins, watch out for the downside!

The alternative scenario is not necessarily a V-shaped recovery in the quarters ahead. Wall Street analysts are currently contemplating various scenarios for different segments of the US (and global) economy. Also because some analysts believe any recession on the horizon will prove to be of the rather mild variety, not the dreadful, fall-into-the-abyss format.

If correct, one potential outcome could be that share prices already have accounted for most of the potential downside in profits. Plus not every sector will be affected at the same time. The more sturdy, defensive sectors might not be affected at all.

Needless to say, the recent quarterly results season in the US has injected some renewed optimism into markets. This can partially explain why ongoing pressures inside the US banking sector have not been met with more selling. Economic data are deteriorating, but they remain inconclusive nevertheless about the economic path forward.

Bonds and equities are not in conflict

A lot of energy is being spent on the apparent discrepancy between US bonds and equities; the first is showing no intention to budge from its (implied) recession forecast, while equities, seemingly, continue to ignore the signal with the intention of powering on no matter what.

All is not what it seems, however. For starters, indices are no longer trending higher, and certainly in the US, most share prices remain in the doldrums with as little as ten stocks generating all the gains thus far this year. But look underneath the surface and one cannot escape the logical conclusion that the bond markets' signalling is increasingly mirrored by equities, as it is by commodities too.

Let's start with the latter. 

FNArena's recently launched Market In Numbers covers nine commodities of which only three are trading in the positive since January 1st: gold, silver, and uranium. Copper, regarded as the most defensive among base metals as supply, is under constraints as much as the demand side and fell slightly into the negative last week.

All others are clearly on the nose in 2023, with WTI down more than -9%, despite OPEC promising less supply, and nickel down more than -20% year-to-date.

This picture is being mirrored in the local share market where the energy sector YTD is the second worst performing sector (only the banks are worse off), beaten slightly by Metals & Mining where the sector performance is close to flat.

In contrast, shares in Telstra (ASX: TLS) are up more than 8%, while other equally more defensive names including Coles (ASX: COL), CSL (ASX: CSL), Transurban (ASX: TCL) and Woolworths (ASX: WOW) are all trading in the positive too.

Note, BHP Group (ASX: BHP) shares are down -4.7% since the start of 2023, Rio Tinto's (ASX: RIO) loss has accumulated to -7% and Beach Energy shares have given up in excess of -12%. Add Harvey Norman (ASX: HVN), down -11.5%, News Corp (ASX: NWS), down -5%, and Incitec Pivot (ASX: IPL), down -14%, and it is difficult to argue the share market and the bond market are expressing sharply contrasting views.

I suspect some confusion stems from the fact that High PE stocks like Altium (ASX: ALU), TechnologyOne (ASX: TNE), WiseTech Global (ASX: WTC), Pro Medicus (ASX: PME) and REA Group (ASX: REA) have continued to trade on elevated multiples, but falling bond yields and a robust growth profile have combined to support those share prices.

The same support has befallen the likes of Goodman Group (ASX: GMG), National Storage REIT (ASX: NSR) and Stockland (ASX: SGP), among others.

Can household savings save the day?

A factor that continues to play a vital role in today's ongoing global debate is unplanned household savings, which are higher because of prior COVID support and economic stimulus. Those savings are still estimated to be as high as 5%-8% of GDP in the US, the eurozone and Japan as of the end of 2022.

Were households to spend their cash surpluses in full, Oxford Economics estimates global GDP growth next year (2024) could be 0.7ppts higher than the currently modelled 2.2%. It would make a significant difference, but not in one direction only as inflation would receive a boost too, and thus central banks might be forced to tighten further, and/or keep interest rates higher for longer.

To an extent, these surpluses explain why the economic ramifications from last year's aggressive tightening have been rather glacial to date with in particular US households having no qualms in spending up while inflation-adjusted incomes are sharply negative. Oxford Economics doesn't think we can simply assume all that is in surplus will be spent across the globe.

One major change this year is the outlook looks a lot more uncertain for many households, which is likely to trigger more hesitant spending behaviour (even as most labour markets remain tight).

On the other hand, the prospect of weakening economic momentum locally might be softened by the support measures included in the latest federal budget announced by the Albanese government. To little surprise, those fiscal support packages have triggered a public debate locally about ramifications for inflation, and by extension for RBA policy.

Contrary to many claims, it's not as simple as "more money in means higher inflation", as also counter-argued by the likes of Jo Masters at Barrenjoey, but these "surpluses" do feed into the growing support for milder economic slowdowns than otherwise might have been the case.

Credit is crunching

With labour markets everywhere more resilient than during historical precedents, one question that remains on many lips is: can we still call a recession without a serious jump in unemployment?

The first thing to point out here is that job losses are traditionally a late-in-the-cycle phenomenon; businesses bide their time and only let go of people they might have to re-hire later on in the final phase of their re-adjustments to tougher conditions. Given the slowing down of economic momentum has taken this long, it is by no means exceptional that we haven't seen any serious deterioration in labour just yet.

Do note: leading indicators are signalling labour markets are set to deteriorate, all else being equal.

The other important point to highlight is that when it comes to the USA, recessions are traditionally not caused by a drop-off in consumer spending; they instead follow significant tightening in credit conditions, a point yet again highlighted during a recent media briefing at JP Morgan headquarters in Sydney.

Here the obvious, non-biased observation to make is that when liquidity turmoil hits the banking sector, as it did in March, already tight credit conditions simply become tighter as vulnerable banks start concentrating on further strengthening their balance sheets, in order to avoid becoming the next victim, and this translates into the approval of fewer loans.

Within this context, most market commentators keep a close eye on the Senior Loan Officer Opinion Survey (SLOOS) to gauge what is happening with credit in the US. It is slowing, though not yet in a catastrophic manner which was recently interpreted as a positive by the more bullish experts.

This particular survey needs some explanation, though. For starters, banks in the US are only responsible for circa 40% of total credit creation for the private sector. Other sources are capital markets, shadow banks, government-sponsored entities, et cetera. Also, similar to the questions asked for the monthly PMI surveys, SLOOS asks banks and borrowers whether credit conditions and loan demand have changed relative to the last quarter.

The latter makes interpreting survey results rather tricky. A lower percentage of banks tightening doesn't by definition mean getting credit is becoming easier; it means a smaller percentage is limiting access to credit even further from the prior quarter.

As also highlighted during the JP Morgan briefing, the SLOOS survey does point towards a significant drop-off in credit availability for small businesses in the US ever since the Federal Reserve started hiking rates in 2022. Historically, there is a close relationship between credit conditions and expectations for further deterioration among small businesses and subsequently a weakening in labour demand from the sector.

As pointed out by economists at Brandywine Global recently: "Small businesses typically are the customers of the community and regional banks, banks that are suffering in this current crisis. That turmoil feeds back into economic activity."

Right now, SLOOS is signalling some 40% of US banks is consistently reporting tightening lending standards. History shows, points out The Macro Compass, every time this percentage surges above 30%, and stays there for at least two quarters, within 2-3 quarters lagging the non-farm payrolls numbers turn negative (indicating unemployment is rising).

Today the 30% threshold is in place, just like it happened in 1989, late 2000 and early 2008. While today's dynamics might be partially different (see also the above), it remains a dangerous proposition for equity investors to assume this time will be different.

The previous three occasions saw US equities subsequently suffer losses in the double-digit percentages (12 months later), small caps more than large caps, with the rest of the world faring worse.

Gold held its own and long-term bonds offered positive compensation. This is also why the JP Morgan briefing highlighted the important role of bonds in diversified portfolios.

To compensate for the limitations offered by the SLOOS data, The Macro Compass has compiled its own TMC Global Credit Impulse Index - the gauge is pointing towards "very weak" trends at the end of 2022, with recent data, including SLOOS, indicating the negative trend is likely to accelerate.

TMC's conclusion is unequivocal: We already are in a credit crunch. But the exact consequences, and timing, remain uncertain, leaving investors still with the opportunity to overweight portfolios defensively.

The economists at Brandywine Global share the sentiment: "...it is likely we are only beginning to see the impact of all the prior cumulative monetary tightening. The combination of this added stress from the banking sector in conjunction with the Fed-generated reduction in liquidity likely will magnify and accelerate the eventual outcome: A recession appears baked into the economic cake."

A historical overlay between the TMC Global Credit Impulse and corporate profits suggests there's more downside yet to come, as the full impact from credit tightening has not materialised yet.

Yet, even in the face of ongoing headwinds for corporate profits, US equity strategists at Citi remain confident corporate profits in the US do not have to deteriorate a lot further from the present level. All in all, Citi projects maybe another -4% in downside potential, and thus relative stability in profits for the quarters ahead.

Citi contemplating various scenarios and their impact on different segments of the market also highlights yet again to investors not every company carries the same level of risk in today's share market.

And as far as the arrival of the economic recession is concerned, finally!, Citi has pushed out its timing to the first quarter of 2024, in line with the shifting consensus on Wall Street.

Markets will not move in a straight line between now and then. Indices might not reflect what's going on beneath the surface.

FNArena offers impartial and independent, ahead-of-the-curve market analysis and commentary, on top of proprietary tools and data for self-managing and self-researching investors. The service can be trialled at fnarena.com.