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Talk of a recession with an uncertain duration is leading many to assess how to position for such a scenario. Some fixed income is surely part of the answer.
What are the odds of a recession?
There is rising speculation of a recession ahead of us due to excessive inflation and tightening monetary policies. While it may take months to figure this out , the odds are indeed increasing. To predict a recession, we need to have stable empirical relationships (for example money in real terms is a function of interest rates and growth) and intense and unexpected shocks. We have the second (Ukraine war/Oil shock), but not enough information to assess the first. Data suggest rising odds of a recession (forecasts on Bloomberg are 33% for the USA and Eurozone 30% (24/6/2022)) amid declining savings and increased borrowing. In addition, corporates and banks have a preview of economic data through their companies’ activities. Indeed, it is interesting to see that Elon Musk for example has a “super bad feeling” about the economy (Reuters 3/6/2022) while the CEOs of Goldman Sachs and JP Morgan have grown very cautious.
How long will the recession last – if it happens?
The duration of a recession is unfortunately not something that is well understood, but it greatly increases in the presence of impaired balance sheets, namely too much leverage and too little expected growth. Examples can be found from the Japanese real estate bubble to the US subprime and Eurozone crises which deeply affected the banking sector and others hampering the transmission of monetary policy. Expectations of an economic recovery depend on credible and sustainable monetary and fiscal policies. After a few months of crisis, growth expectations tend to stabilize. The problem is where – some crises are seen as transient, such as a seismic shock, while others are more permanent, such as a credit crisis. One key aspect of the duration of a recession in Europe is the ability to keep long-term interest rates at acceptable levels in the periphery of Europe. For this, the ECB needs to develop an anti-fragmentation tool that is legally viable. The PEPP for example is significantly restricted by German law. One possibility is for the ECB to offer cheap funding to asset and wealth managers so that they invest in the periphery, but many solutions are possible and we’ll likely see the first preview of this in July.
Source : Nordea Investment Funds S.A. and Bloomberg
Real estate is likely to come under some pressure on the back of higher interest rates and in some cases expensive valuations. Having said this, even after they stabilize, interest rates will stay low and the market likely will be more invested in real assets as equity returns likely will be more moderate in the coming decade. The risk of a recession means positioning eventually more heavily in long-dated fixed income. Covered bonds from the short-end to the long-end offer safety and alpha capability. A recession also means that corporate earnings expectations should deteriorate, but Value/Quality is and should continue to remain appealing as a combination of style. More broadly, diversification across styles helps to transit through a multiplicity of uncertain regimes.
