Since the start of the year, two key risks to the outlook have emerged. The first risk is related to the war in Ukraine. Spillover effects from this conflict are putting pressure on the global economy and financial markets via higher commodity prices. The second risk is a Fed that continues to surprise on the hawkish side. At its latest meeting (March 16th), it signaled a stance that was even more hawkish than its pivot at the start of the year; it sees a labor market that is too tight and inflation that is stubbornly high.
The risk from war: rising food & commodity prices
We are humble in our ability to predict how the Russia/Ukraine situation will play out. Instead, we analyze the potential impact via the primary channel through which the conflict will impact the global economy, namely food and energy prices, which represents a near-term drag on 2022 growth.
Higher food and energy costs will be a hit to the consumer. The impact of higher food and energy costs won’t be enough to singlehandedly push the economies of the U.S. and Europe into recession, and excess savings should help to buffer the impact, but the shock has the potential to induce a notable slowdown. In the analysis below, we quantify the impact on Developed Markets GDP with an assumption of $110/barrel average oil prices (WTI) in 2022, and food prices that are 10% above 2021 levels. For the U.S. GDP impact we also factor in energy and mining capex (which is essentially nonexistent for European countries). The chart below shows the significant impacts across the U.S. and Europe, but importantly shows the slightly lower impact in the U.S. due to lower exposure to imported energy and higher household savings.
A Fed that is more hawkish than its “hawkish pivot” at the start of the year
The March FOMC was the most hawkish that Chair Powell has sounded since 2018, and the Summary of Economic Projections backed up the tone with projections from FOMC participants showing 11 cumulative hikes by year-end 2023 to 2.8%, importantly hiking through what it perceives to be the neutral rate of 2.4%.
The Fed is in the process of imposing a significant tightening of financial conditions, which will likely slow growth on top of an economy that was already set to slow from fiscal drag. Adding in the growth risks from the war in Ukraine, the prospect of easy navigation by the Fed has gone down, in our view. Our base case is that they will likely be able to control inflation by slowing demand amid the turbulence, but the margin for error is low, and our GDP estimates are lower.
We continue to watch our 12-month economic recession probability model1, which is approaching 30% for Q1 2023, and is likely to rise more as the economy progresses further through the cycle. That’s roughly in line with our thinking of roughly 30-35% odds of a recession in 2023. Interestingly, while financial market variables are more volatile, they are currently suggesting a similar probability of recession2.
Putting it all together, the Russia/Ukraine crisis is likely to knock down our 2022 U.S. growth estimate from 4% to 3%, and the Fed tightening to a restrictive level in 2023 shaves down our 2023 growth target to just 1.4% (from 2.25%).
To be clear, our base case is still a ‘soft landing’. By this we mean inflation stabilizes in the second half of 2022 as the Fed hikes, and growth moves towards the long-run average, but not lower. We would still ascribe an approximate 50% probability to this outcome. After all, the U.S. has just emerged out of a very strong recovery, with healthy consumer and corporate balance sheets. Although the Fed may hike seven or more times this year, the absolute level of interest rates will likely be low relative to GDP growth. Aspects of pandemic-related supply-side inflation should cool over the year as supply chains heal and labor supply bounces back. We assign a roughly 50% probability to this scenario.
In this scenario, the overall investment environment will be more constructive in the second half of the year. This is an environment where an equity portfolio with a balanced exposure to growth and value, as well as a focus on quality companies, can perform well. The fixed income space should offer opportunities, particularly as both IG and HY spreads have widened in recent months. The USD is likely to be on the strong side. Gold and oil will likely be range-bound.
The optimistic case: a longer above-trend expansion. In this scenario, inflation comes down more aggressively as supply side constraints ease, allowing the Fed to be more relaxed with the pace of rate hikes. This would result from easing labor pressures in the U.S., commodity prices stabilizing, and supply chains healing. Corporate capex remains strong and inventories continue to rebuild. Demand remains strong on the back of high household savings and healthy corporate balance sheets. We assign an approximately 20% probability to this scenario.
In this scenario, we will likely see a meaningful recovery in risk assets. In equities, both growth and cyclical sectors like industrials can do better. The USD will likely be on the softer side. Emerging markets could also do well. In fixed income, both IG and HY should do well. Gold would be weaker but commodities will likely remain supported.
The bear case: recession. As mentioned earlier, on both our economic and financial market models, the recession probability is at roughly 30%. In both financial media and client conversations, worry is building that an aggressive Fed and/or extremely high inflation could spark a sharper downturn. But it’s important to make a distinction about the type of recession. A ‘normal’ recession generally sees both growth and inflation slowing together. The investment rule of thumb says that as we approach the end of a cycle, one should allocate more to ‘safe’ assets (such as core bonds) and defensive sectors (such as utilities in equities). The USD would be stronger in this scenario, but commodities would do worse. On the other hand, a stagflationary recession is conceivable; where growth slows amid very high supply-drive inflation and rising rates. History doesn’t offer a lot of parallels. Tentatively, we would lean towards allocating more to gold, commodities and real assets.
To conclude, macro uncertainty has risen significantly over the last few months. We still view a soft landing as the most likely outcome for the U.S. economy this year, and therefore we would still advocate for investors to have the bulk of their portfolios in balanced, high quality equities and select fixed income. While a normal recession would typically favor core bonds, a stagflationary recession would favor gold, commodities and real assets. Given the rising probability of a recession, investors should build these protections into their portfolios when opportunities arise.
Footnotes:
1 Source: J.P. Morgan Private Bank, Bloomberg Finance L.P., Haver Analytics. Data as of March 2022. Based on separate probit models run against a recession dummy variable and the following variables back to 1962 or where data are available: Yield Curve (3m/10y), Effective vs Market Mortgage Rates, Consumer and Corporate Interest Payments, Profit Momentum, CPI energy, Output Gap, Real Personal Income, Unit Labor Costs, Capex % Potential GDP, probabilities are averaged to create the composite.
2 Source: J.P. Morgan Private Bank, Bloomberg Finance L.P., Haver Analytics. Data as of March 2022. Based on separate probit models run against a recession dummy variable and the following variables back to 1977 or where data are available: S&P 500 yoy, HY spreads, Yield curve (2y10y, 2y5y, forward 2y10y).
All market and economic data as of March 25, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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