The topic of recession has divided economists and financial analysts over the past year. Although the United States economy met the technical definition of recession in the second quarter of 2022, pundits were quick to point to other data purporting to tell a different story. In the process, the White House tried to rebrand the term ahead of a highly contentious midterm election cycle. Political motivations aside, economists, policymakers, and investors have much at stake in understanding recessionary forces.
Pacific Investment Management Company, also known as PIMCO, believes developed economies will see a “modest recession” in 2023 as central banks ratchet up their fight against inflation. Of course, PIMCO and others discounted the possibility of a full-blown banking crisis unfolding as early as March with the collapses of Silvergate, Silicon Valley Bank, Signature Bank, First Republic, and Credit Suisse. Credit default swaps suggest investors are growing more concerned about bank failures in Europe and North America.
Against this backdrop, PIMCO has identified three prevailing investment themes for the rest of 2023. Regarding portfolio allocation, the investment manager believes bonds are alluring again thanks to improved yields and lower expected volatility.
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1. Inflation Expected to Moderate
The consensus on Wall Street and Main Street is that peak inflation is behind us. The U.S. consumer price index (CPI), a leading barometer of inflation, reached 6% annually in February 2023 from a peak of 9.1% in June 2022. Although some inflation categories are expected to be ‘sticky,’ easing supply constraints and weakening consumer demand suggest cost pressures will continue to moderate. This view jives with the International Monetary Fund’s latest economic outlook report, which forecasts a broad cooling of global inflation in 2023 and 2024.
According to PIMCO, a moderation in U.S. used car and global energy prices should see headline CPI continue to moderate ‘relatively quickly.’ The investment manager believes CPI could fall to 4% annually in relatively short order, though a drop in the Federal Reserve’s preferred target range of around 2% is likely to prove much harder. Additionally, China’s economic reopening is also expected to ease lingering supply chain disruptions without impacting global goods inflation.
2. Central Banks: From Rate Hikes to Rate Maintenance
The Federal Reserve and other central banks have embarked on the most aggressive pace of monetary tightening since the early 1980s, a response to the inflation they helped create during the COVID-19 pandemic. In the United States, the federal funds rate is currently 4.75% to 5%. While this is below the current inflation rate, policymakers are getting closer to pausing their rate hikes, PIMCO believes. The Fed’s dot plot summary of rate projections, released in March alongside its policy statement, indicated that a fed funds rate target of between 4% and 4.75% is appropriate for 2023. Officials see rates going down to a range of 3% to 4% in 2024.
Economists believe the European Central Bank (ECB) will hold interest rates below 4% given the Eurozone is likely approaching recession. According to PIMCO, the Bank of England and Bank of Canada will likely target rates somewhere between the ECB and Fed.
All this to say is the remainder of 2023 will likely see central banks continue to hold interest rates in ‘restrictive territory’ to bring inflation down further.
3. Modest Recession Isn’t Completely Painless
The biggest casualty of restrictive monetary policy, other than asset prices, will likely come from the labor market. The Fed has gone on record as saying that it wants higher unemployment to tame inflation. Using historical data from 14 developed markets, PIMCO estimated that the unemployment rate needs to increase by roughly 0.7 percentage points to bring inflation down by one percentage point.
In practical terms, U.S. unemployment may need to increase to around 5% from the current 3.6% level to have a meaningful impact on inflation. Of course, rising unemployment increases the risk of recession, which most of America’s business economists expect to occur later this year.
In this environment, fixed-income markets offer plenty of opportunities for investors. Corporate credit could perform exceptionally well during a modest recession, while U.S. Treasury Inflation-Protected Securities (TIPS) could offer a buffer against uncertainty. Having cash on hand is also advantageous as it allows investors to add risk to their portfolios if the economic outlook changes.
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