More Trick than Treat

by | November 5, 2022

To begin, we offer our condolences to those impacted by this weekend’s tragic events in Seoul. Our thoughts are with those grieving lost family and friends, and with all those suffering. 

This week, we consider whether we’ve reached inflection points in the economy and markets. Our conclusion, in the language of the holiday, is that while both tricks and treats lie ahead, bitter is more likely than sweet. For investors, buoyed recently by hope, the message is to brace for setbacks. 

Fundamentally, a durable upswing in global equity markets requires the end of monetary policy tightening before the arrival of an earnings recession. Unfortunately, the preconditions for peak inflation and a monetary policy ‘pivot’ are not yet in sight. Meanwhile, recession and earnings disappointments loom. And, ominously, the medium-term prospects for a global economic recovery following the current slowdown have, if anything, worsened. 

We begin with the US economy. On the good news front, the third quarter GDP statistics offered reassurance that a recession has not yet arrived. A still-sturdy labor market and resilient spending in the services sector are keeping the economy afloat, even as investment (residential and non-residential) is falling, accompanied by flagging goods spending. 

Nevertheless, underlying US economic activity is not as strong as last week’s headline GDP numbers suggest, which came in at an annual rate of 2.6%. Strip out contributions from net exports and inventories and real final demand has flat-lined. Meanwhile, the impact of dollar strength and foreign economic weakness are yet to be realized in the GDP numbers. The inescapable conclusion is that a 2023 US recession remains probable.

Labor markets are, for now, the outlier. Even though employment is a traditional lagging indicator, job creation should nevertheless have softened by now following sharp increases in the cost of capital, falling demand for housing and related goods (which are major employers) and rock-bottom CEO confidence (at fifty-year lows). 

The resilience of US employment almost certainly reflects the yawning gap between job vacancies and those looking for work. It may also reflect ‘labor hoarding’ by firms that are reluctant to let go of hard-to-find skilled workers. But as profit margins shrink (see below), firms will have to address costs by cutting jobs. Of all forecasts for 2023, the most likely remains a rise in unemployment.

For investors, that is worrisome, particularly as ‘peak inflation’ has not yet arrived in the US. Without signs that US inflation is receding, it is difficult to foresee relief from Fed tightening. While no one disputes that inflation is a lagging indicator (and that its most important contributor these days, housing, lags overall inflation), the Fed shows no sign of budging from its tightening stance until inflation recedes. 

That is understandable. After all, the Fed has a lousy track record in forecasting inflation (as do most economists) and it fears for its credibility. Accordingly, at this week’s Federal Open Market Committee meeting, the Fed will hike rates another 75 basis points. Just as important, it is unlikely to offer much reassurance of ‘mission accomplished’.

Turning to Europe, something remarkable has taken place. Extraordinary efforts to stockpile liquified natural gas and other energy sources (plus an unusually warm fall season) are apt to see Europe through much of the winter heating season. That is to be applauded.

Nevertheless, grotesque costs of energy, limitations on its industrial use, general uncertainty, and higher interest rates are inexorably pushing the Eurozone into recession, as European Central Bank (ECB) President Lagarde acknowledged last week. In contrast to the US, however, investors are more willing to contemplate a slowdown in ECB rate hikes, which is why last Thursday’s jumbo 75 basis point hike did not rattle markets.

If the US (economic resilience) and Europe (end of tightening) offer tantalizing hopes for investors, the picture from China has darkened. An unrivaled President Xi, intolerant to criticism, cannot countenance the loss of face associated with a reversal of his economically damaging zero-Covid policy. Aware that China’s property market is both a drag on growth and a threat to the banking sector, Xi cannot deploy credit easing to jump-start growth. Meanwhile, a stuttering world economy will worsen China’s export outlook. In short, China finds itself macroeconomically hemmed in. Those banking on China to lead the world out of recession are apt to be disappointed.

Longer term, Xi’s coronation to an unprecedented third term (for the post-1982 Chinese political system) has solidified his political standing while simultaneously eroding China’s economic future. Surrounded by ‘yes men’ (and, yes, it is mostly men), China is slipping into a trap of stultifying rigidity, sapping innovation and opportunity. Turning inward, Xi is mortgaging China’s future as a knowledge-based economy. A nation of engineers is not the recipe for world-beating technological advance. Autarky is a path to mediocrity. The adage of China becoming old before it becomes rich was always a possibility. It is now probable, even more so given its deeply problematic demographics, the result of its flawed one-child policy. 

Finally, and turning back to the near term, global corporate profitability is flagging. This past week tech giants stumbled. Partly, that reflects hubris. Meta’s expensive forays into the metaverse just as its social network revenues stagnates is a firm-specific stumble. But weakening advertising revenues, which drives the value proposition of many big tech names, is cyclical and not fixed by smarter management. And as companies in all sectors prepare to tighten their belts, they will inevitably spend less on enterprise software, weakening the growth trajectories of even the Microsoft’s of the world. 

According to FactSet, the US is in a five-quarter decline in US corporate profit margins. Stupendously, the consensus of company analysts expects that erosion to end by early 2023. Fat chance. There has never been a period if postwar US history when the economy entered a recession and US corporate profits as a share of GDP (a good proxy for aggregate margins) did not decline. 

Recessions in the US and Europe will produce global earnings downgrades, even an outright fall in profits. If equity markets are to overcome falling profits, risk premiums and bond yields will have to fall significantly. Alternatively, markets could withstand cyclical weakness in profits if the medium-term outlook brightens.

Neither is likely anytime soon. 

The Fed will only reverse policy if inflation falls sharply. Risk premiums will remain elevated so long as the economy is weak and the financial system prone to stress. 

But perhaps the biggest challenge to optimistic thinking resides beyond the trough of the recession. Recovery, when it comes, is likely to underwhelm. 

China, for reasons outlined above, is unwilling and unable to be the global locomotive. Europe, for well-understood reasons, is not in the position to unilaterally boost the global growth outlook. The US, hamstrung by poor public finances and facing the prospect of divided government (as the Republicans likely retake control of Congress) cannot deploy fiscal easing. That leaves an unwilling (for now) Federal Reserve in charge. Investors might want to take a closer look at the sluggish recoveries of the early 1990s and 2000s to see how tepid global recoveries are when all depends on the Fed.

Trick or treat? This cycle still looks more likely to deliver the mischievous than the sweet. Investors take note. Now is not the time for complacency. 

About the Author

Larry Hatheway has over 25 years’ experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, a non-profit offering commentary and analysis on the global economy, matters of public policy, and capital markets. Larry is also the founder of HarborAdvisors, LLC, an investment advisory firm catering to family offices and institutional clients worldwide.

Previously, Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making, and multi-asset investment strategy.

From 1992 until 2015 Larry worked at UBS Investment Bank as Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). Larry is widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN, and other media outlets. He frequently publishes articles and opinion pieces for Bloomberg, Barron’s, and Project Syndicate, among others.

Larry holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and resides with his wife in Redding, CT, alongside their dog, chickens, bees, and a few ‘loaner’ sheep and goats.

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