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Macro and Market

Why We Think the U.S. Is Likely Headed Toward Recession

Views You Can Use
By Victor Zhang,Charles Tan,Richard Weiss
Wall Street sign in New York City, USA.

Key Takeaways

We believe recession has overtaken stagflation as the U.S. economic scenario most likely to unfold in coming quarters.

Elevated inflation and tighter financial conditions are weighing on consumer and business behavior, which likely will trigger a downturn.

Regardless of the economic outcome, we believe investors should consider inflation’s effects on stocks, bonds and real assets.

Investors continue to confront a chaotic market backdrop. As the Federal Reserve (Fed) attempts to tame raging inflation with aggressive rate hikes, the economy remains in the crosshairs. Additionally, massive federal debt, broken supply chains, a mounting European energy crisis and expanding geopolitical unrest compound the economic and market turmoil.

Prepare Investors for Potential Economic Backdrops

Given this extraordinary backdrop, we believe advisors should help their clients prepare for three potential economic scenarios over the next several months.

  • Recession: We believe this is the most likely scenario, where moderating inflation (but still topping 3%), negative gross domestic product (GDP) and an eventual Fed pivot to accommodative policy emerge.

  • Stagflation: Previously our most likely outcome, we now think the potential for continued stagflation is fading. Reminiscent of the 1970s, this economic climate features high inflation, continued Fed tightening and weak, but still positive, economic growth. 

  • Goldilocks: This soft-landing scenario of low inflation (3% or lower), GDP growth and a pause in Fed tightening is the least likely, in our view.

What Does Recession Mean for Investors?

The U.S. economy contracted in the first and second quarters of 2022, meeting the technical definition of recession. But a healthy job market largely prevented the National Bureau of Economic Research from calling an official recession.

Yet, looking ahead, that’s likely to change. In our view, tighter financial conditions, in response to elevated inflation, will take a toll on consumer spending and corporate sentiment. Accordingly, we believe these factors make recession the most likely economic outcome within the next few quarters. 

As recession sets in, U.S. Treasury yields likely will fall. We also expect credit spreads to widen more significantly than in a stagflation scenario. Inflation could moderate more quickly than in a stagflation backdrop, but we still expect the inflation rate to remain higher than 3% due to:

  • A supply/demand imbalance in the housing market.

  • The repositioning of global supply chains and the onshoring of production.

  • Elevated energy and agricultural prices caused by geopolitical tensions and deglobalization trends. 

Recession: Potential Investment Implications

Probability of scenario occurring in 2022 is very likely.

Fixed Income

In a recession, consider: 

  • Increasing duration exposure. Diversified strategies with longer durations may offer performance advantages as rates decline. 

  • Maintaining inflation protection. Inflation strategies still appear attractive, given inflation likely will remain higher than average. 

  • Staying high in credit quality. In addition to delivering diversification to investor portfolios, a modest allocation to high-quality investment-grade credit may now provide more attractive yields. However, we believe credit selection is critical to avoid weaker, overly recession-sensitive issuers. 

Equities and Real Assets

In a recession, consider: 

  • Placing less emphasis on style distinctions. Historically, there’s been no clear winner when it comes to growth versus value investing during recessions. Growth beat value on a total return basis in five of the last eight recessions. However, the average maximum drawdown over those periods slightly favored value, based on our analysis of index returns.

  • Looking for sustainable growth. Companies with dependable earnings growth tend to outperform during economic downturns. Economically sensitive value sectors, such as financials, industrials and energy, tend to lag alongside lowered growth expectations. 

  • Emphasizing quality stocks. Quality companies with higher profitability and healthy balance sheets may offer attractive potential. Investors tend to favor quality companies in more defensive sectors, such as utilities, health care and consumer staples. Additionally, we think dividend-paying stocks look attractive for the stability of income they generally provide. 

  • Treading carefully in the commodities market. As consumer and industrial demand wanes, commodities typically lose their luster. However, gold may continue to shine amid falling interest rates and heightened economic and market uncertainty.

  • Limiting exposure to real estate stocks. Real estate investment trusts (REITs) tend to lag as poor economic conditions weigh on residential and commercial real estate markets.

What Does Stagflation Mean for Investors?

Slow growth and elevated inflation characterize a stagflation scenario. Although we expect inflation to peak and gradually subside in the coming months, this process likely will occur more slowly if stagflation takes hold.

We expect stagflation to push the 10-year Treasury yield higher amid significant volatility as slow growth and high inflation collide. We also believe the two-year Treasury yield may increase as the Fed, which remains behind the curve in tightening financial conditions, continues to tighten. Meanwhile, credit spreads, particularly in the high-yield sector, may widen amid weak economic growth. 

Stagflation: Potential Investment Implications

Probability of scenario occurring in 2022 is somewhat likely.

Fixed Income

When stagflation takes hold, consider: 

  • Maintaining inflation protection. We believe inflation-protection strategies, particularly with short durations, are attractive as rates rise and inflation remains elevated. 

  • Focusing on quality credits. Higher-quality short-duration strategies may offer benefits if yield outweighs the effects of spread widening. A focus on credit quality will be important, given the pressures on corporate fundamentals from inflation, rising rates and muted growth. 

Equities and Real Assets

When stagflation takes hold, consider: 

  • Focusing on traditional value sectors. The energy and basic materials sectors typically have benefited from higher commodity prices. Utilities generally have provided dependable cash flows and dividends during economic slowdowns, despite higher inflation and interest rates. 

  • Favoring quality stocks. In this challenging environment, we believe higher-quality companies with less leverage, higher profit margins and reliable cash flows from operations should hold up better. We expect the market to reward firms with pricing power and unique competitive advantages. 

  • Evaluating commodities. Commodities historically have provided high average returns during periods of elevated and rising inflation. However, we believe astute management is required because geopolitics and the ongoing effects of the pandemic may heavily influence performance. 

  • Limiting exposure to real estate. REITs may underperform their long-term averages as mortgage rates rise and the housing market slows. 

What Does a Goldilocks Scenario Mean for Investors?

We believe a “Goldilocks” scenario of a soft economic landing, in which inflation rapidly slows and the Fed pivots from restrictive policy, is highly unlikely.

If inflation moderates and the Fed ends its rate-hike campaign, Treasury market volatility likely will subside. In this environment, we expect Treasury yields and mortgage rates to decline and credit spreads to tighten. 

Goldilocks: Potential Investment Implications

Probability of scenario occurring in 2022 is least likely.

Fixed Income

In a Goldilocks economy, consider: 

  • Evaluating higher-risk bonds. We believe credit-sensitive securities may offer outperformance potential, particularly high-yield bonds and bank loans, which historically have benefited during economic expansions.

  • Focusing on nimble duration management. Modest growth, lower inflation and a Fed pivot suggest active duration management may be warranted as markets and rates adjust to the changing backdrop. 

  • Maintaining inflation protection. We believe inflation strategies still can play an important role in portfolios if inflation eventually settles above the Fed’s 2% target. 

Equities and Real Assets

In a Goldilocks economy, consider: 

  • Looking to growth stocks. Pro-cyclical, growth-oriented sectors historically have outperformed in lower-rate, strong-demand environments. This has been particularly evident in the information technology and communication services sectors, where revenues rely on capital expenditures and advertising spending.

  • Assessing cyclical sectors. Economically sensitive holdings, such as banks and consumer discretionary and industrial stocks, tend to benefit from increased economic activity. Investors typically focus less on fundamentals, such as quality cash flows, in favor of market beta, at least initially. 

  • Limiting exposure to certain commodities. Industrial metals and other pro-cyclical commodities may outperform as economic activity and demand pick up. However, softer inflation correlates with lower prices for energy and food. 

  • Allocating to REITs. We expect REITs to outperform as the housing market recovers. Additionally, lower interest rates typically boost the attractiveness of REITs yields. 

Bottom Line: Inflation Influences Investor Allocations

Whether the economy tumbles into recession or skates into stagflation, we believe elevated inflation will remain a constant. And while we expect inflation to moderate, we also believe it ultimately will settle at a higher rate than we’ve seen in many years.

Persistent, higher-than-normal inflation can erode investors’ spending power over time. That’s why we believe inflation-protection strategies should be core components in fixed-income allocations, even if inflation falls from current elevated levels. 

Elsewhere, we believe investors should consider tactical allocations to interest rate and credit sensitivity, given the uncertain growth outlook. Remaining nimble may be the best tactic among credit-sensitive securities, offering opportunities to potentially capture yield advantages across a range of economic scenarios. 

We believe focusing on quality in equities and real assets will be crucial over the next several months. In our view, companies with the ability to pass on costs to consumers should be able to protect margins from wage and input cost inflation.

A broad emphasis on quality should also help investors navigate a recession. In general, quality companies — those with healthy balance sheets, higher profitability and more stable cash flows — tend to offer attractive performance potential in economic downturns.

Victor Zhang
Victor Zhang

Senior Vice President

Chief Investment Officer

Charles Tan
Charles Tan

Co-Chief Investment Officer Global Fixed Income

Senior Vice President

Richard Weiss
Richard Weiss

Chief Investment Officer

Multi-Asset Strategies

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Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

Diversification does not assure a profit nor does it protect against loss of principal.