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The fear of recession is again with us as in 2008 and the Covid-19 shock. Last week, we focused on the odds of a recession and its duration noting that the odds were rising but difficult to pin down and that a recession would be likely much shorter than one during a credit crisis. This time, we look at the type of recession which may be ahead of us. While it seems to be potentially like a standard recession, it has both elements of the stagflation period in the late 70s and early 80s, with central banks that are far more orthodox than then, and remnants of the Dot.com bubble.
What happens in a standard recession?
A recession is negative growth for at least two quarters typically accompanied by rising unemployment, an eventual fall in real income, lower consumer demand and investments, with currencies falling on the back of monetary easing. During a recession, companies deeply affected by the recession, with overly uncertain cash flows, insufficient liquidity, short-term duration of their debt or excessive leverage tend to default (e.g. CCC tranche). Their survival depends on whether investors and banks assume the recession is short or long as it may simply be an opportunity to invest at distressed levels. The same goes for countries with poor balance sheets, such as Greece and Italy who depend on the development of an ECB defragmentation tool.
Households, especially those at risk, can be deeply affected as they reassess their situation and try to guess the future. Fear and necessity can lead to the rise of large popular movements which would then force governments to loosen fiscal policies and central banks’ monetary policy.
Eventually, time and credible monetary and fiscal policy help the economy to trough and rebound. Historically, we have seen that equities perform strongly when leading indicators start to clearly recover and central banks appear to be on course to easing. The question for all actors of the economy is whether the market believes the recovery will be a usual one or trend growth has fallen – that is a function primarily of the credibility of the authorities. After some jitters, we should see authorities in many countries regain their credibility as inflation eventually fades supporting equities, which is good news for the likes of Europe and the United States.
What is different about this recession?
The key mechanism helping an eventual recovery should be a more rapid than expected slowdown in inflation driven by central bank tightening and commodities becoming more readily available – a process which has already started. In the Eurozone, Morgan Stanley now calls for a recession in the first half of 2023 followed by an economic rebound driven by investments. One of their key concerns is that natural gas reserves will be too low for the winter leading to rationing. In the United States, the key risk is that the labor market has become too expensive relative to productivity gains which could become an issue if corporates fear a long recession, as it would force them to shed labor and favor automation. While there are some expensive investment styles in the United States, the situation has improved significantly since the beginning of the year, faced with what could be the second quarter of negative growth.
Over a few quarters, we should approach a point where equities rally strongly and China might lead this process. Until then, a mixture of styles/multi premia such as Valuation with Quality helps to wait out this period. Eventually, extending duration first into sovereign and then into credit is likely to be the main trade – it is a matter of waiting for the right entry point ever more probable as the fear of recession leads to lower commodity prices. In addition, Covered Bonds continue to be of interest. Finally, secular forces such as ESG continue to be a key investment trend.