Financial update from Brewin Dolphin - 9 December 2022

December 2022

The Weekly Round-up

Friday 9 December 2022

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses the rising chance of a US recession, next week’s Federal Reserve policy meeting, and the relaxation of Covid restrictions in China.

Markets re-focus on recession risk

There was an overall risk-off tone this week as investors evaluated the rising chance of a US recession. Despite the strong US labour market data that was released last Friday, this week saw several US banking CEOs warn about a recession in 2023 and bumpier times ahead. Goldman Sachs CEO David Solomon struck a downbeat tone about the economic outlook and warned of job cuts. Bank of America CEO Brian Moynihan said the company is slowing hiring ahead of a downturn, while Morgan Stanley is cutting 1,600 jobs.

The words of wisdom from these CEOs are worth paying attention to, as their businesses are highly exposed to the economic cycle. These banks also possess vast amounts of consumer spending, credit lending and business activity data that can often provide a prompt or real-time look at the state of the economy. The comments certainly spooked the markets this week.

At the same time, the yield curve inversion has become more extreme. Yield curve inversion is when short-term US Treasury yields (two-year) rise above their long-term (ten-year) counterparts. The reason this happens is that short-term bond yields rise as they are sensitive to interest rate increases, while longer-term bond yields fall as investors expect a slowing economy and rate cuts in the future. Historically, an inverted yield curve has been one of the most reliable indicators of a future recession. The yield curve is now deeply inverted at around 80 basis points, the most extreme in four decades.

Our central view is that a US recession next year is more likely than not, but we acknowledge that there are pathways to avoiding one. These would include a fall in energy prices, higher growth and demand in China, a faster-than-expected decline in inflation, and a meaningful rise in the labour force participation rate. Pessimism on the economic outlook is widespread, which suggests that a US recession is at least partly baked into equity valuations.

Recession likely to be mild

As a recession is now the central scenario for many, the judgement on the depth and duration of it is more relevant. On that front we are cautiously optimistic, as we think the length and depth of the recession is likely to be mild. Labour markets in developed economies remain in good shape, with job openings in abundance. Financial institutions are well capitalised and are unlikely to experience the kind of liquidity crunch that we saw in the 2008 financial crisis. Governments around the world are shielding the most vulnerable from the surge in energy costs, and there are still plenty of pandemic household savings to cushion the blow of the cost-of-living crisis.

That said, the cost of borrowing has risen significantly. 2022 saw the fastest cycle of interest rate hikes in US history, and this is something that will reverberate more visibly in 2023. There will be inevitable adjustments to the years of excesses and imbalances built up in the economy. That could mean a downturn in the housing market, a reduction in borrowing by households, de-leveraging by corporates, and more fiscal prudence by governments in 2023.

It is interesting to look at the collective wisdom of the investment industry, which is often gauged via surveys. Bloomberg just released its 2023 outlook survey of 134 fund managers globally, which we are delighted to have been invited to participate in. The biggest worries are stubbornly high inflation or a deep recession. On a brighter note, while stocks could reach new lows in 2023, many survey respondents see gains skewed to the second half. Better news on inflation and growth could be catalysts for a stronger performance next year, with respondents predicting a 10% annual gain for the MSCI World Index.

An exciting week ahead

Markets have settled at pricing in peak US interest rates of around 5%. There is still a big debate on whether there will be rate cuts next year; traders have pencilled in two 0.25% rate cuts in Q4 2023. The doves believe that inflation will come down fast and the sharp slowdown in the US housing market will spill over to negatively impact other areas of the economy. The hawks believe that the ‘job-rich’ recession means underlying inflation is difficult to come down and the Federal Reserve will have to keep rates elevated for longer.

The US producer price index report showed higher-than-expected input cost inflation. The market’s reaction was slightly negative, as the report supports the hawks’ sticky inflation narrative. However, we are happy with the broad direction of producer prices, which are on a steady downward trend. Meanwhile, China’s producer prices are in deflation territory, meaning it can exert disinflationary pressures on global goods prices. Markets are likely to be very sensitive to any piece of price data until we reach a lower equilibrium on inflation. So, the only certainty is that markets will remain bumpy as we head toward 2023.

Next week brings the all-important US inflation data, which is expected to keep falling, and the Federal Open Market Committee (FOMC) meeting. At the last meeting of the year, the Federal Reserve is expected to raise the Fed funds rate by 0.5%, a downshift from 0.75% in the past four meetings. All eyes will be on the Fed’s latest economic projections including the infamous ‘dot plot’, which shows FOMC members’ expectation of interest rates in the coming years.

The China rush

This week there was yet more evidence that China is pivoting toward a reopening, after three years of relentless Covid restrictions. The latest relaxation measures include abandoning the health code to enter some public venues and transport, reducing testing requirements, and allowing infected patients to quarantine at home. The Chinese markets have been rising in anticipation of signs of reopening, but they have been positively surprised by how fast and broad-based the change was. The Hang Seng China Enterprise Index surged 29% in November, its best month since 2003, though it is worth remembering the surge came from a 17-year low.

While the markets may have got ahead of themselves, and before we get overly excited, we should recognise the challenges and complexities involved in the reopening process. We need to remember the difficulty in rapidly reopening a country with 1.4 billion people with little herd immunity. The upcoming Chinese New Year, often referred to as the “biggest annual human migration”, will be a testing time for China as millions of people travel across cities to visit families. Many health experts are already throwing out gloomy projections of Covid cases, hospital admissions and mortality numbers.

China will face a lot of challenges, but it is clear the authorities are going to support the reopening process. Support has already been announced for the real estate sector, and officials are contemplating a 5% GDP growth target for 2023. The normalisation and reopening of the economy is a welcome development and a wild card for the world economy in terms of both growth and inflation. For the global economy, the normalisation of Chinese activity will be incrementally positive for global demand, at a time when recession looms in 2023. The potential problem it may bring is commodity price inflation, notably in the energy sector. This year, the oil price essentially made a round trip – supported by the war in Ukraine but depressed by China’s lower demand. The direction of energy prices will also depend on OPEC+ actions. Last week, the alliance stuck to its targets, citing global uncertainties.

The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.