Why a global recession is likely in 2023

Investors need to face up to the reality that a global recession is likely next year, which will crush corporate earnings and substantially increase default rates among high-risk borrowers.

Since the start of the year, our models have been forecasting a US recession with a high degree of confidence, commencing in 2023.

Examining the duration of recessions in the post-World War II period, our chief macro strategist, Kieran Davies, finds that they normally run for almost 12 months during high inflation shocks, which is longer than the eight-month interval for recessions experienced during low inflation times.

Inflation-induced recessions are also worse for US equities than low-inflation downturns. In real or inflation-adjusted terms, our analysis suggests that the S&P500 has typically declined by 23 per cent in high inflation episodes compared to an 18 per cent loss in the alternative.

This was particularly evident during the acute inflation shocks in the 1970s when the S&P500 fell by about 35 per cent in real terms in 1970, and by more than 50 per cent between 1973 and 1975.

The rise in inflation at this time was driven by bot and h an OPEC-triggered supply shock, which forced oil prices sharply higher, coupled with demand-side inflation propagated by excessively easy fiscal and monetary policy.

If the global economy goes into recession, it will be the sixth time this has happened since World War II and history implies that these contractions tend to be dominated by weakness in the US and Europe.

The spectre of a recession is not, however, dissuading central banks from lifting interest rates aggressively because they are actively seeking to raise unemployment rates, slow-down wage growth and aggregate demand, and, by doing so, put downward pressure on consumer price inflation.

Indeed, the Bank of England and the Reserve Bank of New Zealand both expect recessions in their central cases and are happy to lift rates notwithstanding this outlook. Over time, other monetary authorities will likely follow suit, releasing forecasts that anticipate economic regression.

Before the pandemic, China was an important source of global growth. But China’s inflated official GDP numbers, which cannot be relied upon signal that growth remains well below its pre-COVID trend.

This reflects President Xi Jinping’s very tough COVID-zero policy, which has shuttered the economy, the wholesale withdrawal of Western companies from China on security concerns, and the large, debt-fuelled overhang in the highly leveraged Chinese property market. (As a share of GDP, Chinese debt is double the average of other emerging economies.)

Whereas the US recession is exclusively an artefact of a huge increase in interest rates, Europe’s woes are being further compounded by surging energy prices. Household electricity and gas prices have soared by more than 70 per cent and 110 per cent in Europe, respectively, compared to 20 per cent and 55 per cent in the US.

Severe correction

The correction in US (and hence global) stock prices is likely to be more severe in this shock because they are starting from much more extreme valuation levels.

The cyclically adjusted price/earnings multiple for the S&P500 peaked at its second-highest level in 140 years in late 2021. At 29 times today, it remains much higher than its long-term average of about 16-17 times.

Crucially, very high core inflation of more than 6 per cent a year is generally associated with much lower cyclically adjusted price/earnings multiples of less than 15 times based on our analysis of S&P500 data between 1950 and 2022.

Central banks are very likely hoping for a synchronised global recession to help attenuate the most serious inflation crisis in 40 years because they have still yet to boost rates by anything remotely resembling the double-digit levels recommended by simple decision-making models, such as the Okun’s law “balanced-version” of the “Taylor rule”.

Last week, this column warned that those claiming the housing market was bottoming out were smoking dope. The daily data published by CoreLogic reiterate that the pace of house price declines has remained very consistent since the end of September.

With the Reserve Bank of Australia deciding to lift interest rates for the eighth successive month in December – moving its target cash rate to 3.1 per cent – borrowers will have to wear an unprecedented 300 basis points of mortgage rate increases.

We’ve noted several times that lenders were only stressing their interest rates by 250 basis points in 2020 and 2021 when dishing out record volumes of fixed-rate loans with an annual cost of only 1.75-2.25 per cent.

And now almost one in four borrowers will have their interest rates jump to 5 to 6 per cent as they switch from fixed-rate to variable rate over the next 12 months.

The RBA’s modelling finds that if they jack up the target cash rate a little higher to 3.6 per cent, about 15 per cent of all Aussie borrowers will have negative cashflows after accounting for only their “essential” living expenses.

Sure, punters may have some spare savings, but after spending so much in the past couple of years, Australia’s household savings rate is now almost back to where it was before the pandemic.

There are two final insights that I want to keep hammering home. The first is that adjusting to the new normal of much higher risk-free (or cash) interest rates will occur at different speeds across different asset classes.

In liquid bonds, it has happened immediately. Likewise, listed equities have rapidly adjusted to the leap in discount rates, but they have arguably been much slower to accept the earnings retrenchment that will come from the looming global recession.

In illiquid sectors, such as housing, commercial property, private equity, venture capital, and the illiquid debt markets, the adjustments to higher rates can take years to be fully reflected in prices.

This is, for example, why a large US fund manager has partially frozen redemptions from their US commercial property trust: investors want to exit at the official trust valuations that claim to reflect the underlying worth of these illiquid commercial properties.

But fleeing investors clearly believe that if these assets were sold today, they would likely be worth a lot less.

This is also why listed property trusts on the ASX are trading at some 30-40 per cent discount to their claimed net tangible assets.

Those NTAs are almost certainly inflated because there is very little trading of commercial property right now: neither investors nor the lenders that finance them want to see huge write-downs of the value of the assets backing both the equity and the debt.

The second key insight is that the asset pricing recovery, if and when it comes, is likely to be much weaker than in past cycles since the global financial crisis because interest rates are not going to zero again, nor are central banks likely to print vast quantities of new money just to bid up the value of all assets by artificially depressing long-term discount rates.

Future asset price growth is likely to track sluggish income growth unless we get a massive cost of capital relief.

First published in the AFR here.