The “R” Word: What Powell and Markets are Telling Us

Is this a recession or not? The answer is yes for some and maybe for others. The Fed raised rates by 75 basis points for the second time in six weeks. Over just four months, its actions exceeded the cumulative raises it made across the whole 2010-19 economic expansion.

The upheaval in the world economy over the past two years has broken many “rules of thumb.” Whatever the semantics over the term “recession,” investors should be more concerned about the outlook for both labor markets and corporate profits beyond the slowing that has already transpired. Inflation remains high. The Fed’s higher rates have accelerated inflation in housing costs. Given all that has been thrown at the US and global economy, there are meaningful factors that suggest it’s still growing. Real GDP in the US has contracted for two consecutive quarters. But net job losses have yet to occur, creating great hand wringing over what to call the current period.

This past week’s optimism reflects higher expectations for a so-called soft landing. This implies that the Fed will get it “just right,” raising rates to drive down demand just enough to cool inflation meaningfully but not so much as to cause the economy to spiral downward. The Fed is beginning to see signs that the economy is more vulnerable, and therefore may be less brash in calibrating policy than its more recent highly confident views suggested. This alone reduces some of the risk of a severe recession.

The US Treasury yield curve does not point to immediate economic weakness, but rather a future drop. The average lead time between significant curve inversions and recessions has been about 10 months. How seriously the Fed takes this is an open question. While an economic collapse is not certain, the depth and duration of the coming period of economic weakness remains unclear. High current levels of US corporate profits are truly at risk with central banks darkening business activity.

Portfolio Considerations

While the 47% gain in US corporate earnings per share in 2021 makes current equity valuations look reasonable, it is much harder to grow profits after a boom. Many argue that financial markets now price in a mild recession. CIO disagrees. In Citi’s view, markets do not price in a collapse in the economy or corporate profits. For markets to “stay in the black” from here, a true recession – one with net US job losses measured in millions - would best be avoided. CIO sees the probability of our RESILIENT and RECESSION scenarios as (disconcertingly) about equal. Which way events unfold will depend on whether corporate profits flounder or actually sink. We also see a ROBUST gain in profits as the lowest probability.

CIO believes equity markets have discounted higher interest rates but have not adequately discounted severe weakness in cyclical industries apart from discretionary consumer spending. CIO emphasizes ownership of equities in non-cyclical industries and those with extremely high credit quality. Eventually, the extremes of any business cycle weakening will mean recovery for the most beaten down components in a new or “refreshed” business cycle recovery.