The R word

A closeup photograph of a yellow American railway crossing sign

For financial professionals only

Please note past performance is not an indicator of future performance, investment returns can go down as well as up.

2022 has seen the worst start for the S&P 500 since 1970, with US indices falling firmly into bear market territory. Heightened uncertainty from rising and persistent inflation, Russia/Ukraine war, supply side constraints, and tighter monetary policies are weighing on consumers, business owners and investors alike. Increasing signs of slowing economic momentum are driving growing fears of the R word – recession.

Demand destruction

The Fed has made it clear inflation is a greater threat to the US economy than recession, and if economic weakness is a short-term consequence of getting inflation under control, so be it.

While painful, recessions usually don’t last very long. Inflation not only hurts but can last a long time if it becomes entrenched. That’s why the Fed is now, arguably belatedly, accelerating monetary tightening to create demand destruction and take some of the heat out of the market, especially the labour market where the job openings to unemployed ratio is at a record high.

Economic outlook is darkening

The most recent Fed projections for interest rates by the end of 2022 are 3.4%, almost doubling the upper range of 1.75% in place today. The slowing effect this will have on consumption, investment, saving and economic activity is unknown, but have resulted in the OECD, IMF and others downgrading their economic forecasts. Economic modelling of the probability of recession now indicates the R word is increasingly becoming the base case for most economists and investors.

Market discounting is well advanced

When looking at the yield curve to see what’s priced in, the Fed has actually overtaken the market, projecting rates to be around 3.8% by the end of 2023. In contrast, the bond market now expects rates to be lower by the end of 2023 versus end of 2022, as economic slowing warrants monetary relaxation as inflation is seen to be rolling over.

Economic Outlook
Source: data from CME Group, Bank of England, Barras Capital Management

Technical recession

For many investors, the R word conjures up doom and gloom, thanks to the experience of deep and long recessions through history.

However, prolonged and painful recessions usually follow periods of notable excess in terms of demand and build up of leverage, leading to balance sheet stress and the need for material action to correct or unwind.

That doesn’t appear to be the case today. Household and the majority of corporate balance sheets are relatively solid, cashflow is healthy and employment strong. So this time the anticipated slowdown is expected to lead to ‘a technical recession’, i.e. two consecutive quarters of negative GDP growth, but not much more than that. The softening in demand from higher interest rates will combine with easing supply side constraints, bringing lower inflation and resetting the economic equilibrium.

Economic cycles

Economic cycles will always continue to exist. They are not to be feared but understood and accepted. Investors learn to recognise the benefit of slowdown as the re-set from which growth can resume and support for the compounding of their returns. While downturns are uncomfortable, they are a necessary cleansing process that underpins stronger returns in the long run, helping investors progress towards achieving their financial goals.

This chart shows market drawdowns of US equities since the early 1970s and their subsequent recovery. The clear takeaway is that economic soft patches yield opportunity for long-term investors.

Market Crises And Recoveries
Source: S&P Dow Jones Indices

Long-term perspective, resilience, diversification and quality

In today’s world of sensationalist media headlines, the tendency for risk aversion is understandable, but history and experience suggests it’s wise to remain disciplined and committed to your financial plan.

Retaining a long-term perspective that allows your investments to grow and compound is essential to support delivery of outcomes in line with expectations. Patience and courage are undoubtedly required, but the rewards will be evident in time when underpinned by a resilient, diversified and quality oriented investment solution.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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