For Approved Qualified Domestic Institutional Investors in China

Strategic Fixed Income: unfortunately, a recession is baked in the cake

All the hallmarks for a recession are baked in the cake but have not washed through the economy yet. Markets will soon be forced to change their focus. (Recorded 25 August 2022)

John Pattullo

John Pattullo

Co-Head of Global Bonds | Portfolio Manager


19 Sep 2022
4 minute watch

Key takeaways:

  • With markets and central banks preoccupied with inflation, the signs of a synchronised growth downturn are not gathering as much interest as they should.
  • Note that the economic cycle still exists, but it has been exaggerated by the COVID response with more of a boom/bust pattern – shorter and more pronounced.
  • Unfortunately, all the hallmarks for a recession are baked in the cake; they just haven’t washed through the economy yet.

Hello, John Pattullo, co-manager of the Strategic Fixed Income Team.  I just want to give you a brief outlook on our macro views going forward..

So, post COVID it has felt very much like a boom/bust economic cycle. And I guess we are all grappling with the kind of dislocations we saw as the economies reopened and we are all getting used to the demand side and the supply side, accordingly.

The economic cycle still exists

What I think the main point is the economic cycle still exists; it’s just been exaggerated by COVID. It’s also been massively exaggerated by monetary and fiscal policy working together, which historically, is really quite unusual, and with the wisdom of hindsight, obviously there was too much demand and limited supply, which is mainly the reasons why we have got the current inflationary backdrop. That itself of course, has obviously been exaggerated by the super high oil price and more recently the gas surge – especially in Europe.

In addition, we obviously have the US Federal Reserve and other central banks round the world who have panicked – late – and with increasingly amount of aggression by raising rates very aggressively into an economy, which was already slowing.

With this regard, we feel it is almost inevitable there will be a recession in the United States and around Europe. It is almost unavoidable; because the pace of monetary tightening is so fast into an economy which is really staggering and spluttering in many ways post COVID – too strong and then too weak. It just can’t avoid it.

Good news and bad news

The good news is I think the narrative and the market and some of the central bankers have really shifted, really from being worried about too much inflation, to now, too little growth. And that is a tough place to be if you are a central banker. But the policy tool really now is demand destruction. And rightly or wrongly you are now seeing this by companies, in different geographies, in different sectors, around the world.

The bad news is from the leading indicators we look at, there is now a synchronised slowdown in economic activity. The central banks seem more focused on telling us how strong the employment markets are, but the employment market itself, obviously, is a classic lagging indicator. The leading indicators we look at around the world would suggest we’re in for quite a pervasive, quite a persistent and quite severe downturn and frankly is unavoidable.

With that in mind, my point about the economic cycle being back, but maybe shorter and more pronounced is particularly valid for the bond community. Whereas – hands up, it would have been a great place to have sat in cash may be for the bulk of this year, now you’ve got to look forward. And, we think growth is fading quite fast, inflation, certainly at the headline level has peaked with the oil price coming off really quite fast, and some of those supply constraints that we’ve all known in trucking, and shipping, and microchips and all the rest of it, are broadly working their way out.

We do expect more volatility, especially in the equity markets, which in our opinion still aren’t priced for a recession. Obviously price-to-earnings ratios (PEs) have come down, have contracted quite a lot, but we still expect a lot more profit warnings and contraction in earnings-per-share forecasts, which broadly speaking haven’t really moved an awful lot.

The hallmarks of a recession 

I think all the hallmarks for a recession unfortunately are baked in the cake but haven’t washed through the economy. So, you’ve got a super strong [US] dollar, you’ve got a really strong oil price, let alone the gas crisis brewing in Europe, coupled with an inverted yield curve, which is the classic sign of impending recession and of course a shrinkage in the growth of money supply and a tightening of financial conditions.

That is a very tough outlook but it reinforces my point – the cycle still exists, as night follows day and that’s an opportunity for asset allocators and an opportunity for bond managers to get long of interest rate sovereign duration.

What lies ahead? 

What we need to see, is really further demand destruction unfortunately, and we expect to see that.

We’ll probably see more volatility from various left field events, not just energy and gas, but may be Taiwan, let alone the property crisis – the balance sheet recession, which is impending in China. And frankly, there is a long list of potential risk off events and in that environment, I think markets will lose their worry about inflation and become laser focused on the lack of growth and the recessionary outlook we see.

 

 

Glossary:

Balance sheet recession: Said to occur when high levels of private sector debt cause individuals and/or companies to focus on saving by paying down debt rather than spending or investing, which in turn results in slow economic growth or even decline. The term is attributed to the economist, Richard Koo.

Earnings per share (EPS): The portion of a company’s profit attributable to each share in the company. It is one of the most popular ways for investors to assess a company’s profitability. It is calculated by dividing profits (after tax) by the number of shares.

Economic cycle: The fluctuation of the economy between expansion (growth) and contraction (recession). It is influenced by many factors including household, government and business spending, trade, technology and central bank policy.

Economic indicators: Statistics about economic activity; used to assess, measure, and evaluate the overall state of health of the macroeconomy.

Fiscal policy: Connected with government taxes, debts and spending.  Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank.

Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.

Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Money supply: Money supply is the total amount of money within an economy. The narrow definition of money supply includes notes and coins in circulation and money equivalents that can be converted into cash easily. The broader definition includes various kinds of longer-term, less liquid bank deposits.

PE (price/earnings) ratio: A way of measuring a company’s value. The measure of the current share price relative to the annual net income earned by the company, per share.

Recession: A period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in gross domestic product (GDP)growth in two successive quarters.

Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. Higher volatility means the higher the risk of the investment.

Yield curve: A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.

 

Any reference to individual companies is purely for the purpose of illustration and should not be construed as a recommendation to buy or sell or advice in relation to investment, legal or tax matters.
John Pattullo

John Pattullo

Co-Head of Global Bonds | Portfolio Manager


19 Sep 2022
4 minute watch

Key takeaways:

  • With markets and central banks preoccupied with inflation, the signs of a synchronised growth downturn are not gathering as much interest as they should.
  • Note that the economic cycle still exists, but it has been exaggerated by the COVID response with more of a boom/bust pattern – shorter and more pronounced.
  • Unfortunately, all the hallmarks for a recession are baked in the cake; they just haven’t washed through the economy yet.