The increasing risk of recession

Major central banks, led by the Federal Reserve, have significantly underestimated the rise in inflation in recent quarters and have therefore pursued an expansionary monetary policy stance for too long.

This was admitted by Fed Chair Jerome Powell himself, when testifying last week in front of the US Senate Banking Committee. Now, the US monetary authorities are aiming for the fastest cycle of interest rates hikes in the last twenty years in order to get inflation back under control.

Capital markets expect key interest rates to rise 3.5% in the US and 1.25% in the eurozone in the second half of the year. In doing so, the Fed and the ECB want to restore their tarnished credibility, even if it comes at the expense of economic growth or full employment. The maneuver massively increases the risk of a policy error, which could trigger a recession. Poor consumer sentiment on both sides of the Atlantic leave little leeway for central banks. Only a rapid re-synchronisation of global supply chains and thus easing inflationary pressure could increase the likelihood of a soft landing.

If we look at the challenging market environment, we would have expected adjustments in corporate earnings forecasts in recent months. While price-to-earnings multiples have fallen by 28 per cent year-to-date, earnings estimates have remained too high, even in the event a recession is avoided. As such, it is very plausible that there will be revisions to earnings estimates going into the second quarter earnings season. Certainly, inflation and growth expectations are already priced in, but there is still a significant potential for disappointment in certain sectors and industries.

In addition, margins in the US are still at very high levels and would necessary have to come under pressure in the coming months, driven by trends such as the decline in world trade, the shift of production back to domestic regions, and the expansion of the supplier base to reduce dependencies. Particularly in highly energy- and labour-intensive industries, caution in required.

As we move into the summer months, patience is also a must. In the current market environment, characterised by low growth and high inflation, visibility is limited. Central banks will continue to raise interest rates and, in the case of the Fed, also gradually reduce the size of the balance sheet as the global economy is slowing down.

Thus, in the coming months, central banks will withdraw the liquidity they have pumped into capital markets in recent years. At the same time, geopolitical challenges will persist, and additional uncertainties are emerging, such as the midterm elections in the US in November or the Communist Party Congress in China in the fourth quarter of 2022. In this market environment, investors should focus on quality and refrain from experimenting as now is not the time to build up risk.

The longer inflationary readings remain stubbornly high, the longer the monetary tightening cycle will probably have to be extended, and the higher the risk of a recession will grow. While valuations have been beaten down significantly year to date, it is hard to say whether they are a bargain at this stage, given that earnings are likely to come down or a recession is coming. While investors have suffered quite a setback this year, it is difficult to get bullish until recession arrives or the risk of one falls materially.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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