Is the widely predicted recession in the developed world still coming?
Economic data prints over the last month have been confusing to say the least – in just three weeks the picture changed completely and market sentiment with it. While our industry is known for claiming how notoriously difficult markets and macroeconomics are to predict, in January even renowned economists like Larry Summers described the global growth picture as particularly difficult to read this time around.
At Prescient, we cautiously monitor economic themes, inflation dynamics, labour market trends and market behaviour based on our deep and point-in-time analysis of our large data sets. Therefore, analysing high frequency data is business as usual for us and we update many of our indicators daily.
In the second half of 2022, we had already picked up a significant slowdown in the global economy. Since then, however, global economic data has been weak, but not recessionary, as many anticipated. Does this give credence to the likelihood that the Fed will be able to successfully engineer a soft landing? The data suggests this is too early to call.
Economic resilience has been highlighted in the January surges in employment and aggregate hours worked, the Institute of Supply Management (ISM) Services survey, and the jump in motor vehicle sales and retail sales. Even if some of these increases are given back in coming months, healthy rises in disposable personal income point to solid gains in consumer spending.
Meanwhile, the disinflationary process has begun but has much further to go. The real Fed funds rate remains negative and nominal GDP, the broadest measure of aggregate demand, rose 6.5% in the fourth quarter of 2022 compared with the previous quarter and 7.5% on the previous year. Such rapid nominal spending growth provides businesses with the flexibility to raise prices and is inconsistent with 2% inflation.
So, while economic growth doesn’t seem to be falling off a cliff, the US Federal Reserve’s job is simply not done, yet. Core inflation seems the key contributor to the Fed maintaining its tight rein on monetary policy. The chart below decomposes core inflation. We can see that core inflation is coming off its peak, but again remains at historically high levels and, thus, tighter financial conditions will still have to run their course.
Figure 1: US Core CPI Contributions
When it comes to where we are in the global economic cycle, the Prescient Economic Indicator gives a detailed and real time assessment. The Prescient Economic Indicator is our proprietary statistical model that incorporates a wide range of global macroeconomic releases and filters out the excess noise, encapsulating the current state of the global economy at any point in time in a single number. The Prescient Economic Indicator includes both hard economic data, such as retail sales, industrial production, and employment figures, as well as soft data releases, such as Purchasing Managers’ Indices and consumer and investor sentiment. That makes it the perfect tool to process high frequency data and keep your finger on the pulse of the global economy in real time. The chart below tracks the real-time state of the US economy. An indicator tracking above the zero line shows that growth is above its long-term trend. As you can see, it is currently tracking below the zero line, but is not exactly in recessionary territory, yet.
Figure 2: Prescient Economic Indicator (US)
So, what does this imply? The regression line below shows GDP on the y-axis and the relevant Prescient Economic Indicator that relates to the GDP on the x-axis. It shows the indicator captures almost three quarters of the US economic trends in real time – an exceptional fit that confirms the model is an accurate reflection of the real-time state of the US economy. With the Indicator currently at a level of -3.00, we can expect the US economy to grow at an annualised growth rate of just 0.8%. Again, this suggests US economic growth is currently weak but not in recessionary territory contrary to expectations.
Figure 3: US Prescient Economic Indicator vs US Real GDP
Based on our analysis of the data encapsulated in the Prescient Economic Indicator, we foresee falling but relatively stubborn inflation and weak, but not necessarily recessionary, economic growth to reflect in the numbers. What does all of this mean for markets? The risk – not our base case but a risk nevertheless – is clearly the Fed becoming more hawkish and keeping interest rates higher for longer. Ever since the Fed pivoted toward raising rates, the central bank believed it would get away with nudging up its Fed funds rate but keeping it below inflation. Historical experience has taught us otherwise, and the reality of a combination of a resilient economy and stubbornly high inflation have tested the Fed before. The recent strong economic data and still high inflation rate could force the Fed to consider a 50-basis point hike in March. Having said that, it’s not all doom and gloom for SA assets in such a scenario. We need to keep in mind that our equities, bonds, and the rand are generally exhibiting strong positive beta characteristics, namely they are highly correlated to a faster-growing global economy.
At Prescient, our investment process is data based and evidence driven. We always base our investment decisions on our investment themes, and strictly anchor these in statistically verifiable facts. As always, it will be this point-in-time, data-driven approach that will help us identify and process information in the timeliest fashion, always ensuring that we adapt quickly to changing conditions – even when, as Summers says, they are particularly difficult to read right now. Thus, we have all the economic guidance we need to remain well positioned for any of the challenges the future holds. DM/BM
By: Bastian Teichgreeber, Chief Investment Officer and Louis Becker, Quantitative Analyst at Prescient Investment Management
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