Dear Investors,
Recession or not? This is the question that most of us are trying to interpret as clear as we can during these days.
I’ve found an interesting paper by Goldman Sachs about it, and in this article you can find the most interesting parts that will help us to answering us at the best.
Not every Federal Reserve hiking cycle and subsequent tightening of financial conditions has resulted in a recession.
Of 15 hiking cycles in the post-WWII period, only nine, or 60% of the cycles, did so.
The cycles that led to recessions can be differentiated from those that did not by some combination of the magnitude of tightening and the pace of tightening.
Let’s begin saying that Goldman Sachs has assigned a probability range of 45–55% to the risk of a US recession in 2023.
A midpoint of 50% and a 10-percentage-point range reflect the uncertainty of our forecast.
A recession is not our base case, and our investment recommendations are based on this 45–55% probability.
Since we at ISG started publishing recession probabilities, we have been quite unequivocal about our forecasts.
As show above, Goldman Sachs probabilities have ranged from a low of 10% to a high of 30%.
The probability for 2022 was 10%.
Since the global financial crisis (GFC), we have never forecast a recession, and except for the brief pandemic-induced recession, the US economy has not experienced one since then.
Key arguments in favor of a US recession
The most compelling and most frequently cited rationale for predicting a recession in 2023 is the speed of tightening conducted by the Federal Reserve and the subsequent tightening of financial conditions.
As the Federal Reserve tightens monetary policy by raising the federal funds rate and reducing the size of its balance sheet, financial conditions are tightened as:
- Interest rates rise across the Treasury yield curve.
- The incremental cost of borrowing across businesses and households increases.
- Equity markets decline, creating a negative wealth effect in which consumers reduce consumption as they become less wealthy.
- The dollar appreciates relative to other currencies, lowering exports as the cost of US goods rises for non-US-dollar importers.
Magnitude of policy tightening
Above you can see the magnitude of policy tightening over the past 10 months has been the greatest and the pace has been the fastest on record since the stagflation of the 1970s and early 1980s.
That period was marked by a ninefold increase in the price of oil from about $4 per barrel before the Arab oil embargo to about $40 per barrel after the Iranian Revolution and Iran-Iraq War.
CPI reached 14.8% in March 1980, and core CPI reached 13.6% in June of the same year.11 In the current cycle, CPI peaked at 9.1%; core CPI peaked at 6.6%.
Key arguments against a US recession
We now consider four factors suggesting the US economy may be able to avoid a recession:
- a balanced economy,
- a shorter lag of policy tightening,
- declining inflation and
- the possibility of fewer Federal Reserve hikes than are currently expected.
Recession – balanced economy
The US economy is even more balanced today than it was at the end of 2021. A more balanced economy is likely to absorb shocks much better than an imbalanced economy.
Recession – shorter lag of policy tightening
According to a Financial Conditions Index growth impulse model developed by Mericle and his team, the drag on GDP growth from tightening of financial conditions occurs sooner than is typically thought by most market participants.
As a result, Mericle and his team estimate that the drag from the tightening of financial conditions will abate in 2023.
Declining inflation
Inflation has peaked and is declining across many drivers.
Recession – less tightening than expected
Goldman Sachs scenario includes the expectation that the Federal Reserve will raise policy rates to 5−5.25%, we also recognize that there is a chance it will not raise rates as much as we expect.
As shown in the above chart, policy rates have typically peaked below the peak of where the market expects the yield on 1-year Treasury bills to be one year from now (1y1y).
In the nine hiking cycles since 1972, there have been two exceptions: 1974 and 1980. All other cases, the Federal Reserve hiked rates to a peak below the peak market pricing of 1y1y.
In this tightening cycle, the peak to date for the 1y1y was 4.7% in early November. It stood at 4.2% at year-end.
If this historical pattern repeats itself, the Federal Reserve may hike only one more time.
Recession – prospective total returns
As shown above, Goldman Sachs expect US and Eurozone equities to be the best-performing asset classes in 2023, with total returns in local currency of about 13% in our base case scenario.
They expect returns of 12% for the MSCI All Country World Index.
Such strong equity returns, if realized, will result in moderate-risk model portfolio returns of 9.0% for taxable clients and 9.8% for tax-exempt clients.
They assign a probability of 50% to our base case scenario.
They assign a probability of 30%, much higher than usual, to our downside scenario across all equity markets.
However, in the US, the full year returns in our downside scenario are relatively muted, at -4%, because US equities already declined 18% in 2022.
Valuations declined from 21.4x consensus earnings at the beginning of 2022 to 17.4x by the end of the year.
In they upside scenario equities should increase by as much as 27% due to lower inflation.
Above-trend growth in the US and higher multiples as investors are relieved that recession risks have abated.
They assign a 20% probability to that case and estimate that our one- and five-year return expectations will be realized even if we have a mild US recession that ends this year.