Why a global recession is likely unavoidable in 2023

AS WE head towards the start of a new year, warning signs that the global economy is headed for a recession are flashing bright red. For one, the US Treasury yield curve remains deeply inverted, with both the 10-2-year as well as the 10-year to three-month Treasury spread sitting at -77 basis points and -83 basis points (as of Dec 4) respectively.

Historically, the shape of the yield curve is considered to be one of the most consistent and reliable indicators; it has predicted all five US recessions since 1980. Furthermore, the likelihood of a recession tends to be greater the deeper the inversion and the longer the curve stays inverted, a situation that we are experiencing today.

Higher for longer inflation

Aside from the fact that markets are already pricing in a recession – which could very well turn into a self-fulfilling prophecy – the global economy is on a much weaker footing today compared to the beginning of the year. Right now, inflation is arguably still the biggest problem in the world, with most countries still facing price pressures broadening beyond food and energy.

In November, flash estimates showed that euro-area inflation eased slightly but was still in the double digits, driven mainly by higher energy and food prices, a consequence of the Russia-Ukraine war. Over in the US, consumer price inflation came in at 7.7 per cent in October, marking four consecutive months of decline. While the drop in inflation is good news for Americans, it is still far from the Fed’s target of 2 per cent.

Consensus estimates show that many investors expect inflation to drop dramatically to within a touching distance of the Fed’s 2 per cent target by 2024. We beg to differ. Looking ahead, we believe inflation is in a structural shift and the decades of low inflation are coming to an end. The world is moving into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead.

While there are several reasons why inflation is likely to stay higher for longer, such as deglobalisation, loose fiscal policies, rising food protectionism and more, an exceptionally tight labour market may be the biggest problem of all. In the US, there are roughly 1.7 vacancies for every person currently registered as unemployed. Thanks to a resilient labour market, workers have greater bargaining power, leading to wage gains. Rising wages also mean that the increased labour costs for companies will have to be passed on to consumers in the form of higher prices, which add to inflationary pressures.

Unprecedented pace of monetary tightening

A robust labour market coupled with stubbornly high inflation leaves the Fed no choice but to continue tightening. During the November Federal Open Market Committee meeting, the Fed once again raised rates by 75 basis points, bringing the upper bound of the Fed Funds target rate to 4 per cent. This marks the fourth consecutive 75 basis points rate hike delivered by the Fed, making the 2022 rate-tightening cycle the most aggressive since 1988. To put things into perspective, rates have gone up by 375 basis points in a span of just eight months.

The Fed, however, is not alone. With inflation at multi-decade highs in many countries, central banks have been tightening aggressively in a concerted effort to curb inflation. This global monetary tightening is now increasingly synchronised around the world, with nearly every major economy jamming on the brakes. Policy has never tilted so overwhelmingly towards rate rises in the past five decades.

The last time this happened, the outcome was a global recession. It’s not hard to see why. The drag on economic activity from the globally synchronised tightening will intensify in the quarters ahead. Growing numbers of economists have warned that this rapid and synchronous tightening can be extremely hurtful to an already fragile economy, especially when consumers and businesses are under immense pressure from higher inflation and borrowing costs. Furthermore, because monetary policy often works at a lag, there is a risk that central banks may overtighten.

Don’t count on Europe or China for growth boost

Outside the US, other major economies such as China and Europe are also not doing well, adding to the risk of a global recession. In Europe, the European Central Bank has responded to soaring inflation with multiple rate hikes, marking a shift away from the negative rates adopted over the last 10 years – a move that will likely weigh on growth.

As winter approaches, many European nations are also facing the spectre of an energy crisis, given their heavy reliance on Russia for energy. With the Nord Stream 1 pipeline to remain shut indefinitely and a full embargo on Russian oil to hit in December, an energy shortage looks increasingly likely. If this materialises, we expect massive production cuts to hit Europe’s manufacturing industry, which will inevitably result in lower economic growth.

In China, in the wake of the 20th National Congress of the Chinese Communist Party in October, signs that the country is leaning towards a top-down state-controlled economy as against a free-market economy are becoming more visible. Geopolitical tensions with the West are also escalating dangerously as the US seeks to contain China’s rise while the latter has vowed to push back against Western sanctions with greater assertiveness. To make matters worse, domestic demand remains very weak amid a property crisis and China’s refusal to deviate from its zero-Covid policy.

Mild to moderate recession in 2023

Whatever the case may be, there is no denying that the global economy is on a much weaker footing than before. The question of a global recession is thus no longer if, but when. With global growth slowing sharply, our base case is for a recession to occur in 2023.

However, the upcoming recession is unlikely to be as severe as the one experienced during the global financial crisis in 2008, as the balance sheets of households and businesses remain strong. The financial system is also more robust than before. Last but not least, the upcoming recession is likely to be inflation driven as opposed to credit driven, which should be less damaging to corporate earnings and equity prices.

As we inch closer towards a recession, investors should consider making some adjustments to their portfolios, such as overweighting fixed income (particularly short-duration bonds) relative to equities. With equities, investors can consider value/quality stocks, which are likely to outperform their growth counterparts in a recessionary environment.

The writer is an assistant manager of the research and portfolio management team at FSMOne.com. FSMOne.com is the business-to-consumer division of iFast Financial, the Singapore subsidiary of Singapore Exchange mainboard-listed iFAST Corporation.