Banking Sector Turmoil Bolsters U.S. Recession Risk
Views You Can Use: Fed rate hikes, still-high inflation and an emerging credit crisis mean that a recession will likely unfold over the coming months.
Key Takeaways
Banking sector turmoil is a significant challenge for the weakening U.S. economy.
Tighter financial conditions, including stricter credit standards, will likely trigger a recession.
We believe prices will remain high, and investors should continue to gauge inflation’s effect on their portfolios.
Recent banking sector turmoil has added a new and substantial threat to the fragile U.S. economy. The resulting credit crunch, combined with the cumulative effects of elevated inflation and the Federal Reserve’s (Fed’s) year-long rate-hike campaign, likely will lead to an economic downturn. Accordingly, we believe investors should consider assets that historically have fared relatively well in weak economies while protecting against above-target inflation.
Recession Appears Imminent
In analyzing the economic scenarios that may unfold over the next several months, we believe recession appears imminent.
Recession: In our view, recession risk remains the most likely scenario. We expect inflation to moderate (but still top 3%) and GDP to contract, which ultimately should trigger rate cuts from the Fed. We think the probability of the U.S. economy slipping into a recession still stands at 70%.
Stagflation: We think the current environment of high inflation, Fed tightening and weak, but still positive, economic growth — is nearing an end. Our analysis suggests that the probability of lingering stagflation is 25%.
“Goldilocks”: This soft-landing scenario, whereby inflation quickly moderates (3% or lower), the Fed pauses and growth recovers, is unlikely in our view. We put the probability of this scenario at 5%.
What Does Recession Mean for Investors?
After contracting in the first and second quarters of 2022, the U.S. economy bounced back in the second half of the year. But we believe the economic backdrop will weaken in 2023. In our view, tighter financial conditions, in response to elevated inflation and banking sector uncertainty, will take a toll on consumer spending and corporate profitability. Accordingly, we believe these factors make recession the most likely economic outcome in coming months.
As recession sets in, U.S. 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 notably 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.
Maintaining inflation protection. Inflation strategies still appear attractive, given that expectations are for inflation to 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 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.
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 ease a bit more in the coming months, this process likely will occur more slowly if stagflation lingers.
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 may widen amid weak economic growth, particularly in the high-yield sector.
Stagflation: Potential Investment Implications
Fixed Income
If 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
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 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.
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?
We believe a Goldilocks scenario of a soft economic landing, in which inflation rapidly slows and the Fed pivots from restrictive policy, is unlikely.
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. 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 Should Remain a Consideration in 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.
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.
Diversification does not assure a profit nor does it protect against loss of principal.
No offer of any security is made hereby. This material is provided for informational purposes only and does not constitute a recommendation of any investment strategy or product described herein. This material is directed to professional/institutional clients only and should not be relied upon by retail investors or the public. The content of this document has not been reviewed by any regulatory authority.