Elusive, Yet Probable: The Looming Recession
Views You Can Use: The slow-moving impacts of Fed rate hikes are delaying the arrival of a potential recession.
Key Takeaways
Resilient economic data and the lagging effects of higher interest rates are keeping recession at bay.
We expect a recession to emerge over the next six months as the effects of Fed tightening filter through the economy.
We believe investors should consider higher-quality and more-defensive securities as the economy weakens.
While many investors and pundits continue to warn of a pending economic slowdown, certain signs seem to contradict these outlooks:
Stocks and other riskier assets have rallied recently.
The labor market remains strong.
The nation’s gross domestic product (GDP) was revised upward in the first quarter, and second-quarter annualized GDP forecasts currently top 2%.
Consumer confidence has improved on moderating inflation rates.
Given these positive metrics, are recession worriers crying wolf? Or are the economic danger signs real and relevant — and simply slow to surface?
Rate-Hike Transmission Lags Point to Potential Recession
Although Federal Reserve (Fed) rate hikes have been fast and furious, they haven’t had a fast and furious effect on the economy. It takes time — anywhere from nine to 24 months — for the economy to feel the full effects of each rate hike, according to policymakers and economic research.
Today’s real federal funds rate stands at 2.5%, suggesting considerably tight monetary policy. However, our analysis suggests we’re only about halfway through the “long and variable lag” associated with a Fed tightening campaign. In our view, the economy should face the greatest effects of the cumulative rate hikes within the next three to six months.
Select data highlight the transmission of monetary policy to the real economy and suggest we’re in the late stages of the current economic cycle:
The housing market, which is typically the first data point to peak as the economy slows, peaked in 2021.
Other than one slightly expansionary month (April 2023), the manufacturing sector has been contracting since late 2022.
Corporate profits and consumer spending have been slowing.
The U.S. Treasury yield curve has been inverted since July 2022. This unusual slope is a time-tested recession indicator. An inverted yield curve has preceded every U.S. recession since the 1970s.
Against this backdrop, we believe investors should consider assets that historically have fared relatively well in weak economies while protecting against above-target inflation.
Downturn May Be Evident by Year-End
In our view, the pace of Fed tightening — 5.25 percentage points within 16 months — and stricter lending standards make recession the most likely economic outcome.
What’s more, even though the monthly annual inflation rate has slowed, the cumulative increase in inflation since January 2021 is approximately 16%.1 This burden will continue to weigh on corporate profits and drag down consumer spending, which accounts for approximately 70% of GDP.
We put the odds of recession sharply higher than the chance for stagflation or a “Goldilocks” scenario.
Recession: We now place a 60% probability of the economy slipping into a recession in the next six months. Despite resilient economic data, we still believe an economic downturn is the most likely scenario. We expect inflation to linger at 3% or higher and GDP to contract, which ultimately should trigger rate cuts from the Fed.
Stagflation: We believe the current backdrop of high inflation, Fed tightening and weak, but still positive, economic growth is nearing an end. In our view, there’s a 30% chance of a stagflation scenario persisting over the next six months.
Goldilocks: A soft-landing scenario in which inflation quickly moderates (3% or lower), the Fed pauses and growth recovers is a longshot in our view. We give this least-likely scenario a 10% chance of unfolding by year-end.
What Does Recession Mean for Investors?
As recession sets in, Treasury yields likely will fall. We also expect credit spreads to widen. Inflation should continue to moderate, mostly from a slowdown in the goods component of the Consumer Price Index (CPI). Nevertheless, we still expect core inflation to remain higher than the Fed’s 2% target due to:
Continued pressure on CPI’s services component, mainly from rising wages and elevated shelter (rent and owner’s equivalent rent) costs.
The ongoing repositioning of global supply chains and the onshoring of production.
Still-high energy and agricultural (food) prices caused by geopolitical tensions and deglobalization trends.
Recession: Potential Investment Implications
Fixed Income
In a recession, consider:
Increasing duration exposure. Diversified strategies with longer durations may potentially offer performance advantages as rates decline.
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.
Maintaining inflation protection. Inflation strategies still appear attractive, given that expectations are for inflation to remain higher than average.
Equities and Real Assets
In a recession, consider:
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.
Looking to sustainable growth. Companies with dependable, secular 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.
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.
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?
In our view, stagflation would 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 would increase as the Fed continues to tighten financial conditions. Meanwhile, credit spreads, particularly in the high-yield sector, may widen amid weaker economic growth.
Stagflation: Potential Investment Implications
Fixed Income
If stagflation takes hold, consider:
Maintaining inflation protection. We believe inflation-protection securities, 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
If 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 debt, 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.
Gauging 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?
If inflation quickly moderates and the Fed adopts a neutral monetary policy, Treasury market volatility likely will subside. In this environment, we expect Treasury yields and mortgage rates to decline, credit spreads to tighten and economic growth to recover.
Goldilocks: Potential Investment Implications
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, small caps. 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. Small-cap stocks could also offer appeal.
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: Consider Inflation’s Impact on Portfolio Allocations
Even if the economy slips into a recession, we believe elevated inflation will remain a challenge. In our view, inflation ultimately will settle higher than the Fed’s target.
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.
More broadly, emphasizing 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.
Andy Pudzer, “Bidenomics Spin vs. Economic Reality,” National Review, July 5, 2023.
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.
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