Mid-year Investment Outlook 2023: our macroeconomic outlook

US recession watch

Despite better-than-expected growth, our US recession indicator still flags a recession as a very likely outcome over the coming 12 months, as it’s at levels that have typically come before a recession. As you can see in the graph, when this indicator exceeds levels of around 50%, a US recession usually follows. 

The drivers of the elevated indicator are an inverted yield curve, declining building permits, and weak consumer sentiment and manufacturing outlook. 

Hope on the horizon

Not all indicators confirm this outlook though. The level of credit spreads (the excess yield required by investors to purchase lower-quality issuers) is currently at levels consistent with a more optimistic economic outcome. However, credit spreads have an unconvincing history when it comes to anticipating a recession and usually only reprice wider after a delay – once a recession is underway. 

Labour market will be key

The biggest sign of whether or not we see a US recession will come from the labour market. In the consumer-centric US economy, a recession can’t come until unemployment rises and consumption declines as a result. Historically, a deterioration in the labour market tends to happen very near a recession or when one has just started. So we’re likely to see investors focus on America’s job market to see where the country’s economy is headed. 

The ’no recession’ scenario

Our base-case scenario of a US recession could be too early or wrong if the US has a continuously strong labour market. This could delay a recession or even transit the economy into a recovery without a recession at all. With an eye on the upcoming presidential election next year, the US government has an incentive to use fiscal policy to keep up economic momentum and contain job losses.

However, while this possibility can’t be ruled out, the reality is that it would be very difficult to engineer while simultaneously keeping inflation under control, which remains a declared aim of central banks and governments.

High interest rate risk

While the first half of this year was marked by tension between resilient economies and elevated US recession risks, one upcoming narrative is likely to be centred around the delayed impact of rapid interest rate hikes. Those rising rates led to concerns over systemic risks in the US banking sector in March. Such developments ultimately determine the severity of economic downturns, along with the US Federal Reserve’s (Fed’s) response to them.

The impact of recent rate hikes

The market volatility experienced by the US banking sector in March was a reminder that the impact of monetary tightening can be sharp and sudden. It’s now been 18 months since the Fed embarked on what was the fastest and largest series of rate hikes in the last 40 years. Its impact on the economy is only starting to appear now. Interest-rate-sensitive sectors, especially where debt or profitability is an issue, are showing some stress.

In particular, commercial real estate companies in Europe and the US are on investors’ radars as high refinancing costs and a wall of maturing loans ($448 billion in 2023 in the US, according to Trepp) are confronted by ‘working from home’ trends that have hit office spaces. 

Defaults rise

Finally, consumers are spending their way through much of their pandemic savings and taking on debt to keep up with inflation. As a result, consumer finance like car and credit card loans have seen defaults rising due to rising financing costs. In the US for example, the average used car loan payment for consumers is up 35% versus pre-Covid, according to Citi and Cox Automotive. While defaults remain contained for the time being, this is mostly explained by the record low unemployment rate. The risk is that once the labour market deteriorates, consumer spending – and with it the economy – declines.

Opportunities up ahead

Overall, the big picture looks uncertain, considering the contrast of positive equity returns and cloudy macro-economic data. It’s challenging to make economic forecasts in this environment, and there are plenty of reasons to be cautious. But we also acknowledge that financial markets have been under pressure for 18 months already. So while we favour a modestly cautious positioning for now, we continue to think opportunities will present themselves later this year – as we said in our 2023 Investment Outlook in January. These opportunities could come from small caps or emerging market equities for example, and potentially the banking sector.