The most advertised recession in history
Despite initial fears of recession and banking crises, the global economy has demonstrated impressive resilience so far. The quarter was marked by the resolution of the debt ceiling issue, which had hung like a sword of Damocles over the financial markets and caused uncertainty. There was no concrete evidence of an imminent recession in the US, and unemployment rates remained historically low, indicating a strong labour market and bolstering consumer confidence. First quarter earnings exceeded expectations, instilling confidence in the markets. Both the US and global economies posted steady growth in the quarter, with the S&P 500 gaining 6.6% as risky assets built positive momentum.
Chart 1: Expected US quarterly real GDP growth (annualized)
The slower pace of central bank rate hikes signalled to markets that the peak of terminal rates and the end of the tightening cycle were near, as inflationary pressures remained subdued over the quarter. Falling energy prices provided relief from cost pressures for businesses and consumers, contributing to an overall disinflationary environment. Although markets had been predicting a US recession for several months, the macroeconomic picture did not provide conclusive evidence to support these concerns. Instead, the global economy showed resilience, low unemployment, disinflationary pressures, and positive momentum in risky assets.
United States
The second quarter was dominated by the highly publicized impasse between Democrats and Republicans over the debt ceiling. However, despite the political drama, equity markets proved resilient, with the S&P 500 recording a solid 6.6% increase in the second quarter. Growth investors, particularly those focused on US mega-cap tech stocks, have had a strong performance thus far in 2023. The Nasdaq index surged by an impressive 36.6% YTD, marking the sharpest outperformance of the tech sector in the past two decades, excluding the post-Covid lockdown period driven by stimulus measures. However, the S&P 500’s year-to-date rally has been concentrated among a few mega-cap stocks. At the same time, the VIX Index has fallen sharply to trade below 14, a level not seen since the pandemic-induced period.
Chart 2: Large tech-focused stocks led the rally in S&P 500
Market sentiment was also supported by US economic data. Following encouraging growth in real GDP in Q1 2023, stronger-than-expected auto sales, housing starts, and employment figures suggest that real GDP growth should continue in the next few quarters. Disinflationary pressures persisted during the quarter, with the inflation rate cooling in May to its lowest annual level in around two years, standing at 4.0%. Although overall inflationary pressures remained subdued, core inflation, which excludes food and energy prices, recorded a significant month-on-month increase of 0.4%. On a year-on-year basis, core inflation remained elevated at 5.3%. At the last FOMC meeting, on June 14, 2023, the Federal Reserve hit the “hawkish” pause button keeping interest rates unchanged at 5.00-5.25%, having raised them ten consecutive times at previous meetings. The median projection for the year-end now points to a Fed funds target of 5.4% implying additional rate hikes in the second half of the year.
Europe
The Eurozone economy exhibited a modest improvement in economic conditions during the first quarter 2023, despite falling short of consensus expectations for GDP growth. However, the release highlighted the resilience of the bloc in avoiding a recession, primarily attributed to factors such as the easing energy crisis, unseasonably warm weather conditions, the reopening of China’s economy, and the implementation of fiscal stimulus measures. Contrarily, the German economy experienced a technical recession in the first quarter of the year, as households tightened their spending habits. Following a contraction of 0.5% in the final quarter of 2022, the GDP for Q1 2023 was revised downward from zero to -0.3%. Germany, as Europe’s largest economy, has faced significant challenges, particularly in the aftermath of the Russia-Ukraine conflict.
Chart 3: ECB implied policy rates
The current economic situation is characterized by elevated inflation and high interest rates throughout the region. In response to this environment, the European Central Bank (ECB) decided to raise rates by an additional 25 basis points at its meeting on June 15. This brings the ECB’s total rate increase since July 2022 to 400 basis points, reflecting its determination to counter inflationary pressures. President Christine Lagarde has repeatedly expressed concern about excessively high inflation over an extended period. In May, headline inflation in the eurozone declined 0.9% to 6.1% year-on-year. Furthermore, core inflation, which excludes energy and food prices more prone to fluctuations, declined by 0.3% to 5.3% year-on-year. Although European equities are considered comparatively inexpensive, the rally observed on the European stock markets lasted until around mid-February. Since then, however, equities have entered a sideways phase, with no clear trend.
China and emerging markets (EM)
After a strong first quarter, Chinese macro data’s latest release revealed a slowdown in activity. Imports dropped by 4.5%, and industrial production grew only 3.5% year-on-year. However, it is important to note that these figures were measured against last year’s depressed data during the Shanghai lockdown. The decline in the property market also accelerated, with property investments falling 7.2% year-on-year in May compared to a 6.2% drop in April. Other indicators such as trade data and May PMIs confirm the lack of a significant Chinese economic recovery. Chinese equities have underperformed global counterparts, and falling industrial metal prices reflect disappointing momentum. The underperformance of Chinese equities by around 8% relative to the MSCI Asia ex-Japan Index in Q2 further highlights this trend. With a CPI close to zero, the People’s Bank of China (PBOC) announced a reduction in key interest rates in June. The seven-day reverse repo rate was lowered by 10 basis points to 1.9% from 2.0%, while the rate for one-year medium-term lending facility (MLF) loans was also decreased by 10 basis points, going from 2.75% to 2.65%.
Chart 4: Topix reached highest level since 1990
Japan’s Q1 real GDP saw a year-on-year increase of 1.3%, propelled by robust private consumption and non-residential investment. Moreover, May’s CPI demonstrated further acceleration, with the Bank of Japan’s key inflation measure rising by 4.3% year-on-year, marking the largest surge since 1981. This encouraging data has bolstered optimism that Japan is breaking free from its previous deflationary stagnation. The major Japanese equity index, TOPIX, outperformed other large developed equity markets in the first half of the year, returning 21.1%. It also reached its highest level since 1990.
Investment conclusions
Despite the economic cycle turning negative, the presence of a resilient consumer base and supportive government policies so far has prevented a near-term recession, reducing the likelihood of a severe downturn. While inflation has reached its peak, it will remain a concern heading into 2024, necessitating the continuation of higher interest rates to address wage inflation. Companies, on average, are expected to fare well as they have adapted to the challenging environment by implementing cost-cutting measures. With the prospect of positive nominal growth, most companies are anticipated to perform satisfactorily, particularly those with pricing power. Overall, a sustained wave of corporate defaults is expected to be avoided. Finally, the global monetary policy tightening phase is nearing its peak.
Chart 5: Yields on credit continue to outperform equities
Bonds: Monetary policy is in tightening mode worldwide, led by the pace of the Fed. Currently, markets are assuming a terminal policy rate close to 5.4%. We continue to favour European loans, IG, non-cyclical US and Scandinavian short-term HY bonds as well as structured credit.
Equities: Equity multiples remain challenged by rising interest rates and vulnerable/shrinking profit margins. Within equities, we continue to favour non-US markets, maintaining a mixed approach.
Our cautious stance with a neutral positioning has been the right action during these extremely uncertain times. However, we believe it is now time to increase risk. As a first step we want to slightly upgrade equities from its minimal underweight position and keep the overweight in “credit exposure”.
Scenario Overview 6 Months
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Base case 65% |
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Base case 65% |
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Asset Class Assessment
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Equities |
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longer, but peak level is in sight”.
~4%, whereas the US Fed is pausing and peak rate is in sight @ around 5.5%.
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| Alternatives | Comment |
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