The odds of a global recession are slim
While opposing forces are pulling the global economy in different directions and the global economy is likely to soften from here, based on our assessment of inflation dynamics, labour market trends and market behaviour and a host of other factors, we do not believe a global recession is on the cards.
Our view is based on our deep and proprietary point-in-time analysis of extensive data sets that we monitor to assess economic dynamics and develop themes that guide our investment decisions. A theme we identified a few months ago was that there would be a continued, broad-based recovery, with strong economic performance across the globe. It has since played out and we have retired it in favour of softening – but not recessionary – economic conditions from here
The opposing forces at play include a strong labour market that supports rapid gains in nominal incomes, while elevated inflation weighs on real disposable incomes. Fed rate hikes are likely to contribute to a slowdown in real GDP growth towards its trend rate. However, our models suggest that the odds of a global recession are very limited.
It is our view that it is only by looking at the data that we can draw the most scientifically correct conclusions – and our Prescient Economic Indicator allows us to do that. In the chart below, we plot the Prescient Economic Indicator, a tool that we use to nowcast economic growth globally.
The Prescient Economic Indicator is a statistical model that incorporates a wide range of global macroeconomic releases, filtering out excess noise and giving us a single number that reflects the state of the economy at any given time. Economic releases contained in the Prescient Economic Indicator include both hard data, such as retail sales, industrial production, and employment figures, as well as “soft” releases such as PMI’s, consumer and investor sentiment. The indicator thus provides us with an indication of the overall trend in the global economy, without overreacting to any individual data releases.
If the indicator tracks above its long-term median, we know we are experiencing growth that is faster than trend. When it tracks below the long-term median, we know we are experiencing below-trend growth – and should be worried about an upcoming recession. The big advantage of using our own nowcasting indicator is that we can avoid using economic data that lags current events. The data clearly suggests that we are nowhere near to any recession and that the global economy is still on a very strong footing. The news headlines paint a very different picture, dominated by indicators that point us towards a recession.
What macro-economic forces would need to be in play for the world to tip over into recession?
While the evidence is our first point of call, given the dichotomy between our assessment of the global economy and increasing expectations of a recession, we set out to identify the factors that could potentially push us into recession. At Prescient, we believe tighter financial conditions would be the biggest risk. Again, our data shows that most of the previous recessions have been triggered by overly tight financial conditions. Having said this, we don’t believe we are there yet. In fact, despite the substantial rate hikes we’ve seen, we consider monetary policy across the globe to be very easy. Central banks are still operating off large balanced sheets. Real rates are negative almost everywhere in the developed world. To get a better picture of financial conditions, we prefer to compare the FED Real Rate to the Laubach Williams Natural Rate, as shown below.
The Laubach Williams Estimate predicts the level of the real short-term US interest rate in the absence of transitory disturbances. In the model, numerous complex factors are included, such as the trend productivity growth, global factors affecting real interest rates and demographic shifts. A current real interest rate that is below the Laubach Williams Estimate points to positive financial conditions at present, with sufficient liquidity to benefit the global economy.
The above suggests the FED is behind the curve. Will they hike more aggressively? We don’t think so! Inflation expectations remain anchored and it has always been our take that inflation is supply-side driven. As we write this, we still believe the demand side is not behind the higher inflation globally. It’s not the stronger labour market and it’s not the strength of the consumer driving inflation higher.
There have been a series of supply issues that have contributed to inflation. After the initial Covid-19 shock, we had a supply shock stemming from the energy markets and that was followed by another supply shock from China’s Covid Zero strategy. So, it is our view that inflation is still supply-side driven – and that we will soon see these bottlenecks abate.
While this sounds like an outlier call, with headlines suggesting otherwise, markets agree with our assessment of inflationary forces. The chart below shows inflation expectations, which remain well anchored, affirming that the FED won’t have to move as fast as investors have priced into the market.
A look into China
China has been a force in driving global growth over the last years, along with other emerging markets, and continued to grow in the first quarter of this year to 4.8% from 4.0% in late 2021, according to official data. However, its economic growth has been propped up by government investments and while export demand was solid, domestic demand remains quite weak.
Our models suggest that, after stronger economic activity in January and February, the Chinese economy started to slow down significantly in March and its economic problems look set to worsen in the near term as a result of China’s seemingly futile attempt to enforce a “zero-Covid” strategy against the highly transmissible Omicron variant of the virus by imposing stringent lockdowns on cities and regions. The impact of these is becoming evident in poor April data. Looking forward, however, we expect China to follow in the footsteps of the western world, where each wave of the pandemic faded eventually. China may also improve the way it deals with the pandemic.
Thus once Covid ceases to be a major drag on economic performance, perhaps in the second half of 2022, growth will likely strengthen temporarily in response to the stimulus that China has introduced into the economy. So, while we acknowledge the long-term drags on economic performance in the world’s second largest economy, namely a declining workforce, excessive debt burdens, more government meddling and some restructuring of global supply chains away from a risky overreliance on China, to name just a few, we don’t think that China’s woes will push us into a global recession either.
How should investors position themselves/prepare for these?
The picture we paint above speaks towards the need for markets to reprice the odds of a recession, which would pave the way for greater appetite for risky assets, which will potentially benefit from a compression in the risk premiums currently priced in but potentially also lower core rates. However, we recognise that asset class returns are driven by more than just economics and thus we rely on a broad set of factors to inform our investment positioning. These include valuation metrics, a close assessment of financial conditions but also a careful and point-in-time gauge of investor and market sentiment. Based on these factors, we have built up exposure in funds to the asset classes that stand to benefit from a stronger global economy, but which are still attractively priced. This points us away from US equities and towards SA equities. We are also positive on SA bonds and the rand.
Whatever the conditions, however, it will be our point in time, data-driven approach that helps us identify and process information in the timeliest fashion, giving us an information advantage and always ensuring that we will be able to adapt quickly and remain well positioned for whatever challenges the future holds. DM/BM
Author: Bastian Teichgreeber – Chief Investment Officer at Prescient Investment Management
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