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CIO raised its subjective probability of recession in 2023 to 40% from 35%

The timeframe for a turnaround could depend on the Fed’s recognition of policy lags amid impatience with inflation. The probability the Fed will swerve away from a dangerous course for the economy seems to be falling.  CIO would subjectively raise the odds of recession in 2023 to 40% from 35%. This is barely below the 45% CIO assigns to the “resilient” scenario of slow growth and gradual deceleration in inflation over the course of 2022-2023.

Future equity returns are strongly enhanced after a 20% decline, and particularly a 30% decline. In a recession scenario, however, the timing of economic recovery would still be far ahead of financial markets usual discounting mechanism. Equities typically rise six months before gains in profits.  Profits have yet to fall.

With this in mind, and despite the steep correction to date, Citi is  keeping its tactical focus on high quality US fixed income and equities with strong dividend delivery in industries with  durable demand.

Investors 20 years ago who did not have the patience to wait or the courage to re-engage with the investments responsible for true growth and innovation missed out on the strongest returns of the two decades past. CIO is also asking investors to consider accumulating shares in beaten down secular growth industries such as cyber-security software, which has fallen 20% in 2022 even with no loss of business activity.

Fed Funds Rate vs WSJ

“Pro-cyclical” Fed tightening argues for higher US fixed income allocations and relatively cautious equity positioning. CIO continues to believe broader financial markets cannot find stability until interest rate markets define a range. With this in mind, the 200-basis-point rise in US investment grade bond yields offers a compelling return for the economic environment ahead. In the past two decades, cash deposit rates peaked about 150 basis points below the Fed’s policy rate on average.

Unfortunately for the economy, the transmission of monetary policy tightening to borrowing costs is taking place much faster than to personal interest income.  Long-term US mortgage rates have doubled to more than 6% in a single year. Long-term US corporate debt yields have risen 200 basis points – a return that could be earned over a period much longer than heightened inflation is likely to persist.