Stagflation in context: Why a major recession remains unlikely
We provide an explanation of stagflation, highlight the regions that could be vulnerable to it and explain why a major recession today remains unlikely
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EUROPE VULNERABLE TO STAGFLATION, OTHER REGIONS LESS SO
US RECESSION RISK CURRENTLY LOW
We have seen talk of recession increasing recently. Partly because of inflation pressures. Investors have also spoken about an ‘inversion of the bond yield curve’, meaning long-term bond yields are lower than short-term bond yields.
Historically, a US yield curve inversion has been a reliable indicator of recession, so it is not a signal we want to ignore. The lead time between curve inversion and recession varies however and can be as long as two years.
Looking at economic trends, the most worrying indicator is the surge in inflation. Historically, inflation rises of this size have caused a recession in the US and other regions. However, this inflation shock is largely due to high demand at a time when supply chains could not cope. In the end, higher inflation dampens demand which eventually lowers prices. Though this dynamic still seems more than a year away.
Our US recession model above combines the yield curve signal with other macro indicators to cast a wider net than solely the bond market. The aggregate US recession risk is still low currently, and against this backdrop, we maintain a modest tilt toward assets that do carry some risk (and growth potential) such as equities in our portfolios and funds.
But the grounds of a possible, though not probable, recession could appear. Very high home prices, rising interest rates and tighter monetary policy (stimulus) create a challenging economic mix. Ironically, central banks themselves could accelerate the path to recession by raising rates and setting guidance too aggressively, and thereby slowing the economy abruptly. This is something we continue to watch closely.
WHAT ARE THE IMPLICATIONS FOR INVESTORS?
While the probability of a major recession still looks low this year, equity markets are not cheap even after the market correction we saw in Q1. It is not the first time markets have been through this type of cycle and it is important to keep a longer-term perspective amid shorter-term fears.
Despite the recent rise in bond yields, they remain low by historical comparison and periods of low bond yields have historically seen good equity returns.
what is coutts doing?
- Diversification. Especially in times when economic narratives are shifting frequently diversification is strategically key in our portfolio construction.
- Quality & defensive equities. We hold equites in quality companies (balance sheet strength, earnings stream) which are better positioned to hold and defend value throughout the specific macroeconomic and geopolitical risks we are currently seeing. As well as this, our sterling portfolios have a heavy weighting in UK equities, which contain a combination of commodity and defensive sectors like health care.
- Underweight bond positions & fixed income diversification. Given the inflation pressures and aggressive central bank rhetoric, we hold a slight underweight in bonds and a larger one in investment grade credit. We have also diversified our fixed income assets. We hold Chinese bonds – China needs to stimulate its economy so these could provide a higher yield – and we hold short-duration bonds in high yield and emerging market debt, as well as financial credit.
The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short term goals