Despite Resilient Economic Data, a Recession Is Still Likely
Views You Can Use: Soft landings have historically been rare, and we expect this trend to continue given the growing financial pressures on consumers.
Soft landings are hard to achieve, and it’s unlikely to be any easier in today’s economy.
High interest rates and the elevated cost of living are weighing on consumers, further fueling recession risk.
We believe investors should consider higher-quality and more defensive securities as the economy weakens.
Forecasters hyping a soft-landing scenario for the U.S. economy have recently been well-represented in the financial media. While we understand their optimism, we don’t necessarily share it. Indeed, the economy has been surprisingly resilient despite mounting challenges, but we believe a change is brewing.
History partly accounts for our position. In previous periods of economic stress, soft landings have been uncommon. Additionally, higher prices for everything from weekly groceries to mortgage loans are straining consumers’ wallets and represent another slowdown sign.
Soft Landings: A Disappointing 4-for-12 Record
The U.S. economy hasn’t yet absorbed the full effects of the Federal Reserve’s (Fed’s) rate hike cycle. That process can take 18 months, on average. In the meantime, history demonstrates how the economy has responded to previous bouts of Fed tightening.
The Fed has initiated 12 tightening cycles in the last 63 years. Only four rate-hike programs ended in soft landings, while the remaining eight resulted in recessions. Importantly, those soft-landing periods have little in common with today’s economy.
For example, each soft landing followed a modest pace of Fed tightening and no inflation spike. In the current cycle, the Fed has hiked rates by 5.25 percentage points (through November 2023), and inflation peaked at 9.1% in June 2022. Furthermore, today’s tight bank lending standards contrast with the easing of standards that characterized the four soft-landing periods.
Consumer Pressures Highlight Economic Risks
In our view, the pace of Fed tightening, high interest rates and stricter lending standards make recession the most likely economic outcome. Additionally, although the annual inflation rate has slowed since peaking in mid-2022, it remains well above the Fed’s target.
Moreover, consumer prices have been on a nearly three-year surge, and the cumulative effects are taking a toll. Between January 2021 and September 2023, headline inflation rose nearly 18%. Against these growing pricing pressures, the Fed recently reported that consumers have depleted their excess savings.1
Meanwhile, automobile and mortgage loan rates have soared to multiyear highs, while prices for cars and homes have continued to climb. Also, the student loan repayment freeze recently expired, meaning higher monthly payment obligations for 27 million federal student loan holders.
We believe these financial burdens will continue to weigh on corporate profits and drag down consumer spending, which accounts for approximately 70% of gross domestic product (GDP). For these reasons, we put the odds of recession sharply higher than the chance for stagflation or a “Goldilocks” scenario.
Recession: We 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 stronger-than-expected 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.
Source: American Century Investments. Opinion as of 10/25/2023. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice. The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund.
What Does Recession Mean for Investors?
As recession sets in, U.S. Treasury yields likely will fall. We also expect credit spreads to widen. Inflation should continue to moderate, mainly 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
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 income levels they have historically provided.
Looking to sustainable growth. Companies with dependable, secular earnings growth have tended to outperform during economic downturns. Economically sensitive value sectors, such as financials, industrials and energy, have tended 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, we believe 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) have tended 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
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
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 — have tended to offer attractive performance potential in economic downturns.
Francois de Soyres, Dylan Moore and Julio Ortiz, “Accumulated Savings During the Pandemic: An International Comparison with Historical Perspective,” FEDS Notes, Board of Governors of the Federal Reserve System, June 23, 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.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
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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