Facts, numbers and scenarios on the American and international economy. The analysis by Colin Graham, Head of Multi-Asset Strategies at Robeco
We can compare the debate on a possible recession of the world’s largest economy to the “Schrödinger’s cat”, a thought experiment conducted in 1935 by the Austrian physicist Erwin Schrödinger, a pioneer of quantum physics.
Schrödinger hypothesized that a cat in a locked box could be both alive and dead at the same time depending on whether a radioactive atom disintegrated or not. If it disintegrated, emitting radiation, a bottle of poison would break and kill the cat. Only opening the box would reveal with certainty the state the cat was in.
We can apply this experiment to the US economy, because currently no one knows its true state. There are those who believe that the economy is already in recession (two consecutive quarters of negative GDP growth), those who expect only a slight slowdown and those who see an opportunity to make long-term investments. Consensus swings frantically between these different views on a weekly, daily, or even hourly basis.
Only with the passage of time, more data and a retrospective lens will it be possible to reconcile these two states of the economy and market participants will be able to open the metaphorical box. A further complication is the fact that we do not have an adequate baseline, since recent history, from the first lockdowns imposed to combat Covid to the subsequent spikes induced by fiscal stimuli, has distorted the starting point of the analysis.
In a future perspective, the economy is affected by some structural changes, hybrid work and blockchain, so even the reference scenario traced in this phase of volatility is questionable.
If the United States sneezes, the world catches a cold
The health of the US economy is vital for multi-asset investment planning, as it affects the value of trillions of dollars of stocks, government bonds, corporate bonds and the dollar itself. A recession induced by increases in interest rates implemented to combat inflation would cause a decline in both stocks and government bonds, complicating the process of allocating capital.
The US economy has suffered from many problems over the past 12 months: rate hikes, commodity and supply chain shocks, soaring cost of living and excess demand. However, indicators such as employment, inflation and the cost of housing continue to signal ‘a buoyant economy’.
In our view, this confirms what we already knew: that the US economy was in great shape before the aforementioned problems came. Monetary policy has abandoned the ’emergency’ framework and financial conditions have tightened due to the rise in rates and the strength of the US dollar.
As a result, central banks are reconsidering the second-order effects of inflation and are opting for a more data-dependent approach. In our opinion, the monetary authorities have decided to favor a real-time assessment of the state of the economy. In other words, looking at inflation and employment levels is like driving a car by looking in the rearview mirror.
Stocks and bonds have different outcomes
Investors are far-sighted and try to predict return levels over different time horizons; this is one of the factors that explains the inefficiency of the markets..
In June, using our scenario analysis, we saw that recent market lows for equities and recent highs in credit spreads were starting to discount different outcomes, with worse prospects expected from the high yield segment.CopyAMP code
The catalysts for a possible turnaround were the decline in interest rate expectations, the decline in bond yields, the slowdown in headline inflation and the generation of earnings, combined with a very bearish positioning. A very powerful combination capable of triggering a risky asset rally.
Downside risks are increasing
Looking ahead, US consumer confidence is weakening with the decline in purchasing power; the index of economic accessibility for those who buy a house for the first time is at the lowest recorded in 2006 and 1989, which does not bode well in view of the winter.
Corporate balance sheets are solid enough and some sectors have passed on the increases in input prices to buyers, but generating profits will become more challenging and confidence in the levels of future earnings currently discounted in prices is questionable.
As a result, the decline in valuations may be more pronounced than expected. As we approach the end of the year and approach the opening of the Schrödinger box, which will reveal the true state of the US economy, we believe the downside risks are increasing.
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