Braced for a bumpy ride

Financial markets came under yet more downward pressure in June. Equities felt some relief from relentless selling pressure as investors began to scale back their expectations for interest-rate increases into 2023. But rallies were short-lived and US stocks recorded their worst first-half drop in more than 50 years by month-end. Government bond markets also sold off until it became clear that investors had shifted from worrying primarily about inflation to worrying primarily about the risk of a global slowdown, driving demand for the safety offered by government debt.

Energy prices are the big risk

Our base case is still that core inflation (i.e. with volatile food and energy prices removed) will fade back to normal levels by the second half of next year and that there will be no global recession in the next six to 12 months. This is important for financial market prospects. But the risk of a world-wide recession is nevertheless significant – we put it at roughly 30%. We believe the chance of a recession in the UK and certain countries in Europe is higher (above 50%).

Much of the jeopardy stems from the war in Ukraine and the potential for another jump in energy prices that stifles growth. The price of oil has fallen back toward $100 following its earlier spike to $130, but gas prices are rising once again in Europe after Russia cut back supplies to several countries. If Russia shuts off the flow of energy to Europe entirely, it would cause massive economic pain to both sides. In Germany, for example, such a move would leave its GDP 5% lower than it would otherwise have been, if its government’s economists are correct. Considering that the long-term trend for German growth is 1.25% a year, that would be a very punchy hit to one of the world’s largest economies.

There’s also a risk of central banks overdoing their interest rate increases in an attempt to tamp down inflation. Higher borrowing costs could push households and businesses over the brink, leading them to go bust or slash spending. Less demand for goods and services leads to lay-offs, which of course snowballs into even less demand and tumbles down the hill to recession.

But the jobs market is holding up

But, while news has been pretty miserable for most of the past six months, it’s important to note there are still reasons to be optimistic. Crucially, the jobs market is holding up well. Hiring continues at a strong pace: in the US, an average of 400,000 jobs are being created each month and hiring intentions remain elevated. This dynamic makes it very difficult for a recession to begin. The outlook for new employment is much weaker in the UK and in parts of Europe, where the economic data are already particularly weak and – as outlined above – we believe the risk of a recession is much greater. The UK, of course, faces some unique challenges, with the slump in the value of the pound accelerating amid the political crisis engulfing Prime Minister Boris Johnson’s government.

Right around the world, consumer confidence surveys are at or near record lows. But people in many countries are still spending at levels that belie what pollsters are reporting about confidence. And household savings in developed countries are much higher than might be expected. We estimate that savings in excess of the historic norm total an incredible 13.5% of GDP in the US and a still substantial 5.5% across developed countries as a whole. In the US, there’s evidence to suggest that these savings are more equitably distributed than might be expected. Bank of America data show that households with total income of less than $50,000 a year have nearly twice as much money in their accounts today than they did this time three years ago, for example.

Could there be a silver lining in market falls?

It’s far from easy to predict the future from these contradictory clues. Investors have priced in a very high chance of recession – much higher than we currently recognise outside of Europe. The US S&P 500 index has already fallen by almost the total amount it falls in an ‘average’ recession (i.e. one that’s characterised by typical economic ups and downs rather than one that’s amplified by a financial crisis). Stocks have priced in so much bad news that it may not take much better news to trigger a sizeable rally.

That said, there are clearly plenty of reasons to be cautious and no immediate catalyst to ease investor fears. We may still be a couple of months away from any meaningful easing in volatility. Because an imminent global recession appears unlikely, we continue to believe it’s best to stay invested in stocks for now. But we’re defensively positioned given the broadening risks, with a skew towards those companies, like utilities, healthcare and consumer staples, which tend to be less affected by tougher economic circumstances.