Weighing the Odds of a Recession
As the recession narrative grows louder, are we headed for a soft or hard landing? Fred Demers, Director and Investment Strategist, Multi-Asset Solution Team, addresses these concerns and shares his macroeconomic outlook and strategies.
September 2022
Key Takeaways
- Central banks see no reason to pause rate hikes as job vacancies surpass one million in Canada and 10 million in the U.S.
- The downturn has primarily impacted discretionary spending and housing
- Comparing today’s economic data to that of the 1970s, and defensive portfolio positioning for maximum capital preservation
For Central Banks to combat inflation, they often need to cool the economy. Given recent comments from the Federal Reserve (Fed) and the Bank of Canada (BoC), how much more economic pain should investors expect?
FD At the moment, it’s too early to tell. A key distinction in our view will be the state of the labour market. Due to the current labour shortages, we believe there will be less hardship than in 2008, and likely even compared to a typical recession. However, in Canada and the U.S., the unemployment rate should increase by one to two percentage points over the next year. Despite this hurting some people, the unemployment rate would still be historically low. What does this mean overall? I’d say the labour market’s cushion is favourable for the recession outlook. It’s certainly not new. It was prevailing before the COVID-19 era and, if anything, only amplified as we came out the other side. In Canada, for example, there are more than one million job vacancies across the country as of June. In the U.S., that number jumps to north of 10 million — a level twice as high as pre-pandemic. There are still a lot of people missing from the labour force, and several industries are facing challenges keeping staff and attracting new ones, which is causing upward wage pressure. As a result, the Central Banks will need to see more pain and evidence of demand destruction before they scale back on rate hikes.
We’ve seen inflation pare back, but some of the biggest market concerns have persisted, such as the war in Ukraine, ongoing supply disruptions, and domestic price pressures. Considering the conflicting indicators, what is the probability of a soft or hard landing?
FD Because of the labour market outlook, I would lean toward a softer type of landing. But there is an element of wishful thinking around these views. Many households are complaining about wages not keeping up with inflation. They see their wealth under pressure, both through equities, fixed income, and now real estate assets. Households remain in good shape in many cases compared to 2020. However, given how much price appreciation we’ve seen, wealth gains are coming down quite sharply from the peak, which will weigh on the consumer outlook. The income effect is also very important. When households keep their paycheques, inflation will likely hurt big-ticket spending. For instance, think of a home renovation and the appliances that come with it. Right now, people are cutting spending on those major projects, as well as travel and leisure. But of course, you need a roof over your head and food to eat. So what we are seeing is a “discretionary recession,” especially for lower income households.
Overseas, energy prices are expected to rise as we head into winter. If Russia cuts supply and the crisis worsens, will Europe be the first to tip into recession?
FD Likely, yes. The situation is quite alarming. European energy prices are already skyrocketing, and preservation measures are being put in place. But I think the worst is still ahead. In energy-intensive industries, such as manufacturing, we’re likely to see activity shut down or capacities reduced. And regarding expectations, policymakers are just starting to brace the public for the pain ahead. Looking forward, energy prices are bound to increase as demand grows amid the cold weather and supply continue to dwindle. Recently, we saw Gazprom – one of Russia’s major energy companies – reduce flows further through their Nordstream pipeline. The volumes are low versus pre-invasion and continuing to come down. The truth is that there could be a complete shut-off of energy supplies from Russia to Ukraine. So as much as the conflict remains very local, the economic impact is now global, with Europe front and centre.
When you look at the data, are there similar economic scenarios in history? And did they result in a recession?
FD When you think about the inflation story, the closest example is the 1970s. The big difference is demographics. Today’s population is aging, which is not as inflationary as the in the 70s when Baby Boomers were all climbing corporate ladders, asking for higher wages every year. There are similarities on the energy side, however. In 1973, the Organization of Petroleum Exporting Countries (OPEC) issued an embargo against the U.S. Now there is another one against Russia. I would also argue that the pace of the energy transition is almost like imposing another type of embargo on the energy outlook. While climate action is indeed a high priority, we are telling companies that by 2030 or 2035, there will be no more internal combustion engines. We’re saying that we want a complete transition. Then, at first signs of a supply crunch, we turn around and ask, can you please pump more oil? Well, of course, they’re not going to do that. The policy is creating extra stress on the energy supply. I also think there is a lack of willingness to go into debt to support the economic outlook. That said, we likely wouldn’t need a lot of stimulus to minimize the damage — differentiating this time from the 70s. In the end, every cycle is unique.
The Canadian housing market has entered a correction, which some call a “housing recession.” What does this mean for investors?
FD For investors, the biggest concern is how the weaknesses in the housing market fit into the bigger picture on interest rates and consumer sentiment. After all, lower prices is part of the central banks’ plan, and housing is doing exactly what you expect in a rising-rate environment. In the first half of this year, we saw a buyer strike as people cautiously rethought the housing outlook. This had a negative impact on prices, bringing them down from their peak earlier in the year. Now, mortgage rates are up, which means the monthly calculation for buying a property has increased — it’s not the same when you have an interest rate of 4% compared to a mortgage at 2%. But the reality is you need a roof over your head. And if we look at the demographic and immigration flow in Canada, they are still extremely positive.
The second stage depends on how well the labour market holds up. Going back to the idea of a “discretionary recession,” people will sacrifice their night out at the movies to pay for their mortgage and other essentials. But if people start losing their jobs, the market will see more fire sales, and the cycle can become more vicious. Of course, we watch housing carefully, but ultimately, the core view depends on the employment situation and layoff news. The media often amplifies these stories, but the reality is that job loss is still pretty low overall. From what we are seeing, there has to be some moderation on the outlook within the next 18 months.
You previously said that now is the time to think about a recession. Can you expand on your stance and explain your positioning?
FD In our initial assessment of the invasion of Ukraine, we figured the war would be short-lived — and many others felt the same. Of course, that is not exactly how it played out. Now, the economic conflict is tremendous, and the ripple effects are far-reaching. For this reason, we downgraded our outlook. And, there are a lot of question marks surrounding where we are right now. But the direction has been clear, and we’ve seen our portfolio positioning move away from a pretty significant overweight situation in equities versus bonds at the beginning of the year. Now, we have small to moderate underweight to equities. Since we think the rate hike schedule isn’t done, we are also underweight in fixed income assets and have a significant overweight to cash in this environment. Our approach is maximum capital preservation. Could we get even more defensive? Yes, we could. But in my opinion, the recession playbook takes several months to play out. It’s full of uncertainty — not only as you roll into a recession, but even as you leave one. As the narrative gets louder and the timeline to recession gets shorter, you’ll want to start liking bonds and interest rate duration. But we aren’t there quite yet.
We often ask investment strategists to provide a book or podcast recommendation for our Advisors audience. What are you reading or listening to lately?
FD I find the classics fascinating. Currently, I’m reading Leadership: Six Studies in World Strategy by Henry Kissinger, a book about the values and aspirations of those who lead. When you try and understand geopolitics, it’s usually on the more subtle side of policy. But I think it’s useful to understand these leaders’ agenda or goals, if you will. Often, in the markets, we’re stuck in short-term analysis, understanding today or tomorrow’s move — sometimes losing touch with the longer-term perspective. Kissinger has his biases, but the book provides good background on globalization and how policies are driven by leaders with long-term views.
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