A global recession is likely unavoidable in 2023. Here’s how you can prepare for it.

• Both the 10-2 year and the 10 year – 3 month treasury spread are negative, indicating that a recession may be on the horizon. 

• The current global rate tightening cycle is the most synchronised and aggressive in recent history. The drag on economic activity will intensify in the quarters ahead as the full impact of monetary tightening is eventually realised. 

• With a relatively robust labour market and stubborn inflation, the Fed will be forced to continue tightening, or risk letting inflation spiral out of control. The risk of over-tightening is now greater than ever.

• Tighter monetary policy is starting to bite, with leading indicators pointing to a slowdown. Consumer spending is set to weaken further as borrowing costs rise and savings dry up.

• Beyond the US, Europe is also struggling with high inflation and a potential energy crisis, while China economy faces stagnation as domestic demand remains weak and the government leans towards a state-controlled economic model.

• Our base case is for a recession to occur in 2023. However, the upcoming recession is expected to be milder than the one experienced in 2008 as the balance sheets of both households and businesses remain strong.

Inverted yield curve rings recession alarm bells 

As we head towards the beginning of a new year, warning signs that the US economy is headed for a recession are flashing red. Among the various indicators, the shape of the yield curve is considered to be one of the most consistent and reliable. 

Since 1980, every recession has been preceded by an inverted yield curve. The 10-2 year Treasury spread successfully predicted all five recessions, with only one false alarm in 1998. The 10 year - 3 month Treasury spread is even more accurate, having predicted all five recessions without a single false alarm. An inverted yield curve is therefore a leading indicator of a recession, and the likelihood of a recession tends to be greater the deeper the inversion and the longer the curve stays inverted. 

As of 17 November, the 10-2 year Treasury spread is currently at -66 bps, and it has been inverted since July. Meanwhile, the 10 year - 3 month Treasury spread, despite having turned negative only recently is already at -55 bps (Figure 1).

Figure 1: Both the 10-2 year and the 10 year – 3 month Treasury spreads are negative, indicating that a recession is on the horizon

Unprecedented pace of monetary tightening across the world 

During the November FOMC meeting, the Fed once again raised rates by 75 bps, bringing the upper bound of the Fed Funds Target Rate to 4%. This marks the fourth consecutive 75 bps rate hike delivered by the Fed, making the 2022 rate tightening cycle the most aggressive one since 1988 (Table 1).

Table 1: The current rate tightening cycle has been the most aggressive of them all 

The Fed, however, is not alone. With inflation at multi-decade highs in many countries and pressures broadening beyond food and energy prices, central banks across the world have been tightening over the past year in a concerted effort to curb inflation. This global monetary tightening is now increasingly synchronised around the world, with nearly every major economy jamming on the brakes. Policy has never tilted so overwhelmingly towards rate rises in the past five decades (Figure 2). 

Figure 2: The simultaneous tightening of monetary policies around the world has been unprecedented

The last time this happened, the outcome was a global recession. It’s not hard to see why. The drag on economic activity from the globally synchronised tightening will intensify in the quarters ahead. Already, growing numbers of economists have warned that this rapid and synchronous tightening can be extremely hurtful to an already fragile economy, especially when consumers and businesses are already under immense pressure from higher inflation and borrowing costs.

Even central bankers, who initially held out hope that inflation can be brought down without the need for a recession, have changed their tune. Jerome Powell has said that higher rates could bring some pain ahead, while officials at the European Central Bank (ECB) have warned that hits to growth and unemployment may be necessary to tame inflation.

According to the Fed’s latest projections, unemployment in the US is expected to reach 4.4% in 2023, nearly a full percentage point higher than the 3.5% (12-month low) recorded in September. In the history of the US, the unemployment rate has never risen by 0.5 percentage points above the preceding 12-month low without triggering a recession (Figure 3). This means that if the Fed’s forecast were to be true, it is only a matter of time before a recession occurs.

Figure 3: A robust labour market leaves the Fed no choice but to continue tightening

Risk of overtightening looms as labour market stays strong

Even after several rounds of rate hikes, the US labour market continues to remain resilient. October saw jobs growth rising by 261,000, much higher than the median consensus forecast of 193,000 jobs (Figure 4). Although there have been layoffs (mainly in the tech sector), hiring activity in the services industry (healthcare, leisure and hospitality) remains robust, accounting for the majority of the job gains. While the unemployment rate has risen from 3.5% to 3.7%, it remains relatively low compared to historical standards. 

Figure 4: The US labour market remains tight as job growth continues to beat expectations 

America’s tight labour market continues to be a pain point for the Fed, which has long said that in order for inflation to fall, unemployment must rise. Thanks to a resilient labour market workers have greater bargaining power, leading to wage gains. Rising wages also means that the increased labour costs for companies will have to be passed on to consumers in the form of higher prices. 

Even as recent inflation data came in lower-than-expected, one month does not make a trend. As long as the labour market remains tight inflation will likely stay elevated. The Fed will likely continue tightening, thus increasing the risk of a recession. 

Global growth to deteriorate further, leading to a recession 

Tighter monetary policy is starting to bite.

According to the latest data published by the Conference Board, the US Leading Economic Index (LEI) has been on a downtrend since June 2021 (Figure 5). CEO confidence, a barometer of the health of corporate America is at the lowest level since the Great Financial Crisis (GFC), with more than 98% of US executives anticipating a US recession in the next 12 to 18 months. Things are even worse for Europe, with more than 99% of respondents expecting a recession there. Both measures suggest that economic growth is likely to deteriorate further in 2023. 

Figure 5: Leading indicators point towards a slowdown in the economy

PMIs, another leading economic indicator not captured within the LEI, also points to a decline in economic activity. While it is understandable for manufacturing PMI to fall as consumption shifts from goods to services following the reopening of the economy, services PMI surprisingly showed a steep contraction October, reflecting a broader slowdown in business activity. 

The US is not the only country to face a slowdown in business activity. With global growth slowing and the Fed tightening leading to greater inflationary pressures, PMIs across most major markets are also on the decline, reflecting the headwinds faced by the global economy (Figure 6). 

Figure 6: Global composite PMI at the lowest since June 2020 as headwinds mount 

Consumer spending, which accounts for roughly two thirds of the US economy will likely continue to decelerate as households face a toxic mix of high inflation and soaring interest rates. Over the past few months, inflation-weary consumers have increasingly relied on savings and credit to keep spending. This is observed by the savings rate, which has fallen to 3.1% in September, way below pre-pandemic levels of around 9%. Meanwhile, credit card balances reached a total of USD 887 billion in 2Q22, just USD 40 billion below the all-time high of USD 927 billion back in 2019 (Figure 7). 

Figure 7: Consumption increased at the expense of lower savings and higher credit card debt

What is troubling is that rising policy rates also means higher credit card interest rates. After three consecutive 75 bps rate hikes prior to the FOMC’s November meeting, the average interest rates on credit cards has risen to 16.27% in August, from 14.56% in February. Delinquency rates are also starting to pick up, although they remain near an all-time low (Figure 8).

High credit card interest rates increases the debt burden for American consumers, which discourages spending, leading to a slowdown in consumption. Combined with an extremely low savings rate and a darker economic outlook, consumers will likely cut back on spending.  

Figure 8: High credit card interest rates is spurring a rise in delinquency rates 

Don’t count on Europe or China to boost global growth 

Outside of the US, other major economies such as China and Europe are also not doing well, adding to the risk of a global recession. Over in Europe, most countries are struggling with high levels of inflation, with consumer prices in the eurozone reaching a record high of 10.7% in October. The ECB has since responded with multiple rate hikes, marking a shift away from the negative rates adopted over the last 10 years - a move that will likely weigh on growth. 

As winter approaches, many European nations are also facing the spectre of an energy crisis, given their heavy reliance on Russia for energy. Prior to the war, Russia supplied approximately 40% of Europe’s natural gas and 30% of its crude oil. With the Nord Stream 1 pipeline to remain shut indefinitely and a full embargo on Russian oil to hit in December, an energy shortage looks increasingly likely. 

If this materialises, we expect massive production cuts to hit Europe’s manufacturing industry, which will inevitably result in lower economic growth. 

(Related Article: Trouble persists for Europe – downgrade to 2.5 Stars “Neutral”)

There was, however, some hope that China’s economic reopening and aggressive stimulus could help to drive global growth, just as it did back in the global financial crisis when China was a key growth engine at a time when the rest of the world was suffering. This time round, China is clearly not in a position to do so.

The outlook for China, the world’s second largest economy is looking increasingly shaky after the conclusion of the 20th National Congress of the Chinese Communist Party in October. As President Xi embarks on his third term, signs that China is leaning towards a top-down state-controlled economy as against a free market economy are becoming more visible. Geopolitical tensions with the west are also escalating dangerously as the US seeks to contain China’s rise while the latter has vowed to push back against western sanctions with greater assertiveness. 

To make matters worse, domestic demand remains very weak amidst a property crisis and China’s refusal to deviate from its zero-Covid policy. Just recently, health officials reaffirmed China’s commitment to zero-Covid as cases rose to a six month high.  As China becomes increasingly isolated from the world coupled with weak domestic demand, its economy faces stagnation.

(Related Article: Downgrading China: New economic regime and rising geopolitical tensions bode ill for China’s future)

Positioning yourself for a global recession 

All in all, with most major economies on a much weaker footing than before we think that the question of a global recession is no longer if, but when. With global growth slowing sharply, our base case is for a recession to occur in 2023. However, the upcoming recession is unlikely to be as severe as the one experienced during the global financial crisis in 2008, with the balance sheets of households and businesses remaining strong (Figure 9). The financial system is also on a much stronger footing than before.

Businesses have also taken advantage of the low interest rate environment during the pandemic to refinance their existing debt at lower rates and for longer durations. Importantly, the Basel 3 capital standards introduced after the global financial crisis has forced banks to hold more capital, fortifying the financial system against any systemic collapse.

Figure 9: Consumer balance sheets today are stronger compared to before the GFC

As the global economy sails towards a recession, the strong earnings growth delivered by most companies post-pandemic are likely to be unsustainable. Lower revenues, high inflation and borrowing costs will result in margin compression, which leads to lower, or even negative earnings growth. And because share prices are predominantly driven by earnings, that would also mean that equities have limited upside ahead. 

In terms of positioning, we have a preference for fixed income over equities, particularly short duration bonds. Short duration bond yields have climbed significantly higher as compared to long-term yields, meaning investors can receive higher yields without taking on much duration risk. The Nikko AM Shenton Short Term Bond SGD, LionGlobal Short Duration Bond Cl A Dis SGD, and the United SGD Fund Cl A Acc SGD are some options to consider. 

Investors who wish to retain exposure to equities can consider US value stocks, which are likely to outperform their growth counterparts in the current environment. Alternatively, investors may also look beyond the US for markets with lower valuations such as Japan, or even ASEAN for its earnings resilience. 

Table 2: Recommended products 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report holds a NIL position in the abovementioned securities.