The Signal and Noise series from Janus Henderson’s Portfolio Construction and Strategy Team seeks to identify historical patterns and precedents through which we can view current market challenges, escape analysis paralysis and drive toward an actionable set of portfolio solutions.
In our recent article, which looked at the U.S. yield curve and the U.S. economy, we aimed to demystify the relationship among yield curve inversions, recessions and negative U.S. equity S&P 500® returns (spoiler alert: inversions are good at predicting recessions but are no better than a coin flip for predicting negative returns). In this second instalment, we look at the root of the recession question: Is it likely for U.S. gross domestic product (GDP) growth to turn negative over the next year?
Ongoing economic disruptions from the Russia/Ukraine war, tightening financial conditions, supply constraints, broad-based inflation … there is no shortage of potential drags on U.S. GDP. But a drag is not a recession: baseline U.S. GDP remains strong and will require a sizable drag to turn negative, thanks to the ongoing post-pandemic demand rebound alongside strong public and private spending.
Let’s examine two of the largest factors detracting from that reasonably healthy baseline:
- Russia/Ukraine War and Energy Prices: Due to commodity price increases, financial shocks and decreases in Russian demand, the Organization for Economic Cooperation and Development (OECD) estimates the war will detract about 0.9% from U.S. GDP in the first full year following Russia’s invasion of Ukraine.1
- Rising Rates: The fact that consumers will see – or have already seen – increases in mortgage and other lending rates is just one example of the impact of the Federal Reserve’s recent monetary policy tightening. These changes take time to percolate through the economic system, however, so detractions to U.S. GDP won’t be immediate. Absolute Strategy Research projects monetary conditions are likely to detract 1.0% from GDP by the middle of 2023.2
Consensus estimates for 2022 and 2023 U.S. GDP growth are 3.5% and 2.3%, respectively. Besides the unprecedented 2021 GDP rebound, the estimated GDP growth for 2022 is still the highest since 2004, and 2023’s estimate is above the trailing 20-year average of 1.9% (Exhibit 1).
Exhibit 1: Historically Strong U.S. Growth
2022-2024 Estimated U.S. Annual Real GDP Growth vs. Trailing 20 Years
Source: Bloomberg, as of 31 March 2022.
Since the beginning of this year, consensus 2022 and 2023 U.S. GDP growth estimates have already been reduced by 0.2%, which gives a sense of scale for the relative size of drags versus baseline growth. All of which is to say, the overall U.S. economic growth picture is historically good – even accounting for the aforementioned drags.
That said, a pessimist might reasonably fear that some negative developments could come in faster and more violently than expected. In that scenario, too much drag occurring too quickly would make a small, annualized number a much larger short-term number, which would quickly and easily push the U.S. into recession. On the other hand, an optimist would be reasonable to doubt the total drag would hit 1.9% and/or think U.S. GDP baseline growth will beat estimates.
Putting the broader recession question aside for a moment, now let’s focus on the potential drags coming from the monetary policy side, which is generating endless headlines at the moment. Fortunately, history shows us that equity markets have generally been able to perform in the midst of tightening cycles.
The appropriate grain of salt to accompany these historical scenarios is, of course, the high inflation in our current environment. However, with so much uncertainty around the trajectory of both inflation and growth, coupled with what history says about the potential for markets to perform in the midst of a tightening cycle, market timing in this situation can be extremely difficult – and potentially extremely punishing to long-term returns (Exhibit 2).
Exhibit 2: S&P Performance is Hardly a Drag During Tightening Cycles
S&P 500 Returns Before, During and One Year After Historical Tightening Cycles
Source: Morningstar, Janus Henderson Portfolio Construction and Strategy Team. Past performance is no guarantee of future results.
Whether you take an optimistic or pessimistic view, it’s important to understand that we are entering a lower growth regime. Rather than attempting to find an answer to the recession question, we think investors should instead focus on finding portfolio solutions that have the potential to thrive amid slowing growth and increased volatility. Here on the Portfolio Construction and Strategy Team, we seek to identify solutions that are not only well-suited for this volatility, but which can also help address the asset allocation gaps and concentrations we see in each investor’s unique portfolio through our custom consultations.
1“OECD Economic Outlook, Interim Report March 2022: Economic and Social Impacts and Policy Implications of the War in Ukraine.” OECD iLibrary, March 2022.
2 “Rising Rates…and recession risks?” Dominic White, Absolute Strategy Research, April 5, 2022.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.