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There are two downside risks to the outlook for the economy and markets.
The first is rates higher for longer because of sticky inflation driven by high wage inflation and the ongoing recovery in the housing market.
The second is the ongoing tightening in credit conditions with banks holding back lending.
We are carefully monitoring both of these risks.
Our banking sector outlook is available here.
See important disclaimers at the bottom of the page.
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The consensus has been forecasting negative growth since October 2022, and the recession has yet to arrive because it has taken longer to run down excess savings in the household sector, see chart below.
Put differently, it is taking longer to remove from the economy the $5trn fiscal and $5trn monetary expansion done during covid.
On the back of stronger-than-expected growth, the correction in stock markets and credit spreads has been relatively limited despite the rapid increase in short rates.
With inflation still at 5%, far above the Fed’s 2% inflation target, the Fed will keep the costs of capital high, and the recession will come as households eventually run out of excess savings.
The implication for markets is that the Fed will continue to put downward pressure on earnings growth and employment growth until they get what they want, namely lower inflation.
See important disclaimers at the bottom of the page.
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The BoJ will likely exit yield curve control later this year. This presentation looks at what the consequences will be for USDJPY, US credit, and US rates.
See important disclaimers at the bottom of the page.
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My latest outlook presentation is available here.
See important disclaimers at the bottom of the page.
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The interest coverage ratio for the investment grade index is currently near all-time high levels, see chart below.
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What makes the coming recession so unusual is that it is happening after almost 15 years of money printing, which never really had any major positive effect on GDP growth. Instead, the 15 years of money printing created a significant bubble in asset prices.
As a result, the big correction during this recession will not be in the economy but in asset prices as the Fed continues to deflate the buy-everything bubble created due to global easy money.
A mild economic recession with a big recession in asset prices is what we call a non-recession recession.
With inflation currently at 5%, well above the Fed’s 2% inflation target, the ongoing correction in asset prices will continue as the costs of capital will stay elevated well into 2024.
See important disclaimers at the bottom of the page.
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The stock of CRE debt outstanding today is significantly smaller than the stock of residential mortgage debt outstanding in 2007, see chart below.
As a result, this recession will be milder than in 2008, but it will likely be longer because the required correction in CRE prices will be spread out over a longer period.
See important disclaimers at the bottom of the page.
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A survey of 67 banks in the Dallas Fed district carried out in early May shows that credit standards have tightened significantly since SVB collapsed, and bank credit conditions are now at 2020 levels, and the deterioration continues, see chart below.
Combined with still tight IG and HY spreads, the Fed will look at this and conclude that tighter credit conditions are needed to get inflation down from currently 5% to the Fed’s 2% inflation target. In particular in a situation where households are still sitting on plenty of cash, see also this new Fed working paper, which finds that consumers have plenty of excess savings left at least until the end of the year.
See important disclaimers at the bottom of the page.
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The consensus expects a recession starting next quarter, but the upside risk to this negative forecast is that consumers still have plenty of savings left, see also this new Fed paper, which finds that households will not run out of excess savings before the fourth quarter of 2023.
See important disclaimers at the bottom of the page.
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It is surprising how narrow high yield credit spreads are given the ongoing tightening in credit conditions in the banking sector, see chart below.
See important disclaimers at the bottom of the page.
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