The massive infusion of tight policy in ‘22 should start to really take hold of the economy in ‘23
Vanilla recession is mostly likely outcome, with symmetrical risks
Don’t confuse a Fed pause with pivot
Remain cautious on risk-adjusted returns and still prefer higher-quality assets
Following significant monetary tightening in 2022, we expect the cumulative effect of a higher cost of capital to work its way through the economy in 2023, slowing both inflation and growth. Therefore, the overarching theme of 2023 is that restrictive monetary policy should cool inflation but likely at the cost of creating a recession. Note, this is more negative than the current consensus which calls for a soft landing/growth recession. The upshot for our forecast is that washing the deck clean faster should allow for a larger rebound, illustrated by our ’24 forecast ahead of consensus.
Exhibit 1: Annual US GDP growth
As investors look to the Fed for signals of a potential policy shift, it will be important to not confuse a pause for a pivot—the Fed is likely to pause and leave rates at a sufficiently restrictive level for a lengthy period of time before it contemplates a rate cut. What’s more, before pausing, the Fed is expected to slow the pace of rate hikes as it attempts to evaluate the impact monetary tightening has had on the economy.
The Fed has consistently recognized elevated, persistent inflation as one of the greatest near-term risks to the economy. Like the Volcker Fed of the 1980s, the Powell Fed is primarily focused on fighting inflation in this tightening cycle. This “Volckerized” Fed mode is different from previous tightening cycles where inflation was subdued, and the primary driver of policy was moderating growth to prevent a boil-over from occurring. The main implication of this difference translates into a policy rate that is “higher for longer.”
2023 is where the ‘rubber’ of this Volckerized policy rate meets the ‘road’ of economic activity. The result is demand destruction which will ultimately bring aggregate supply/demand back into equilibrium and rectify the recent broad price pressures; however, in a $25 trillion economy, this re-balancing takes time.
We have already seen the consumer being squeezed. Faced with higher interest rates, lower real incomes, lower household net worth, and waning fiscal support, households have increasingly drawn on excess savings built up during the pandemic in order to sustain their consumption patterns. If these drawdowns continue at their current pace, excess savings will be depleted by mid-2023 and, in the process, expose the contraction in real purchasing power.
Exhibit 2: Cumulative excess savings (Baseline Q1 20 in billions)
The impact of higher interest rates has clearly been seen in the housing market, where a rapid surge in mortgage rates has sharply reversed the pandemic-driven housing market boom. Through September, home prices have declined for three consecutive months. Housing’s contribution to GDP is already down 15% from the cycle peak last year. We project this slowdown to continue into 2023 as higher rates hurt demand.
Exhibit 3: Total Existing Home Sales Avg, % (LHS)
NAR 30-Year Fixed Mortgage Rate Avg, %, United States, SAAR, Thous (RHS)
The Fed pausing rates at a restrictive rate will also be contractionary for businesses. More specifically, on the investment side, we expect the higher cost of capital to curtail capital investment in 2023 as there is typically a 9- to 12-month lag between a business’s capital investment decisions and their impact on the real economy.
By definition, this demand destruction will prove to be dis/deflationary. We have already started to see an easing of good pricing on the heels of the Russian energy shock passing and supply chains unclogging. That said, as we head into 2023, concerns remain that a tight labor market will continue to result in sticky services inflation. Therefore, if the Fed is to reach its stated inflation target of 2%, unemployment will likely need to increase to approximately 5.5% over the coming quarters. This would be roughly a 2% reduction in the employment base and is a key driver of our recession call.
Overall, the initial outlook for corporate earnings power is not very optimistic over the coming quarters. In fact, there has never been a recession in which EPS has not declined. Yet, the consensus is for the earnings of the S&P 500 to be +4-5% in 2023. Even if the earnings only decline by 10%, low by historical recession standards, that boosts equity multiples by over 2.5 points to an expensive 20x. We believe this puts downside risk to equities (or at least caps the upside) until greater clarity of sustainable earnings growth unfolds. This conclusion dovetails with our recent paper exploring asset class returns following curve inversion.
Risks: The main risk to our call is that inflation recedes faster and thus the Fed can pivot mid-’23 (i.e., the consensus view). For this to occur, unemployment would have to move up quickly; a Fed pivot with an unemployment rate sub-4% would likely lead us back to an overheated situation pretty quickly (déjà vu Arthur Burns’ Fed). Given the current strength of the labor market, the requisite steep climb in unemployment might be difficult, though we acknowledge the risk.
Asset Allocation: There is a growing disconnect between our views and the market, the latter of which is pricing in a soft-landing scenario that avoids recession. From an asset allocation perspective, our view translates into a strategy that still favors a defensive tilt towards (1) fixed income over equities and (2) prefers high quality over low-quality bonds. While investment grade credit may widen out a little bit more in a recession, we still think its risk adjusted returns should be more viable than equities and high yield credit in this environment. If our forecasts prove correct, sometime in 2023 there will likely be an opportunity to shift sizably into lower-quality high yield credit and equities. Typically, this happens once you are in the throes of the recession and can start to see the end game. As a result, we recommend maintaining dry powder that can be deployed to take advantage of the opportunity.
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