By Vivien Lou Chen
The financial market’s first-half fear of an imminent U.S. recession is in the process of being replaced by a new storyline. It features what one Goldman Sachs strategist calls a “latent” risk of an economic downturn in the next 12 months and a perhaps not-so-hard landing, as central banks keep raising interest rates to curb inflation.At Goldman Sachs Group Inc. /zigman2/quotes/209237603/composite GS -0.68% , researchers put the market-implied risk of a U.S. recession starting within one year at a year-to-date high of 37%, as shown in the chart below. And while the threat of stagflation hasn’t gone entirely away, it may look something more like “quasi-stagflation” or an environment with “stagflation tendencies,” said Christian Mueller-Glissmann, a managing director and London-based head of asset allocation for Goldman Sachs.
Underlying the latest shift in thinking is the notion that the U.S. economy may be better equipped to handle higher interest rates than previously thought, in contrast to the first-half pessimism that prevailed .
Signs of the sentiment change are most evident in U.S. stocks, which have bounced back from their mid-June lows but were lower Friday morning after divergent comments by Fed officials on the path of interest rates. On Richmond Fed President Thomas Barkin said the central bank will “do what it takes” to get inflation back to its 2% target, though not immediately, and that process might mean “a recession could happen”, Bloomberg reported .
Goldman Sach’s conclusions came as U.S. stock and bond markets had pivoted into a wait-and-see mode for much of Thursday. Before Friday’s morning selloff in both stocks and bonds, “an environment of indecision” had prevailed in Treasurys as “investors put policy angst on hold in favor of sidelined positions,” said BMO Capital Markets rates strategists Ian Lyngen and Ben Jeffery.
Read: Fed doesn’t want to ‘overdo’ rate hikes, San Francisco president Daly says and Fed’s Bullard says he is leaning toward backing 0.75 percentage point hike in September “In the first half of the year, markets had been really worried about the risks of imminent recession, because central banks have to fight this incredibly high inflation. That risk has gone down,” Mueller-Glissmann told MarketWatch via phone. “The problem is you can still have this traditional recession unfold, where central banks are tightening policy, yield curves are flattening, and there’s a growth backdrop that’s deteriorating for a few quarters.”
“A traditional recession takes time to build” and, in such a scenario, “you can expect earnings expectations to turn more negative,” he said. “That latent risk over the next six to 12 months is the same or higher than it was before. Our base-case view is that if we get a recession, in most economies it’s likely to be pretty soft; the only place where it would be deeper is Europe. But that doesn’t change the view that one of the steepest rate-hiking cycles on record will likely hit earnings and that markets will have to reprice risk.”
All three major U.S. stock indexes stayed lower Friday morning, after Barkin’s comments, led by a 1.8% drop in the Nasdaq Composite /zigman2/quotes/210598365/realtime COMP +0.80% . Dow industrials /zigman2/quotes/210598065/realtime DJIA +0.26% were off by 0.7%, and the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.36% was down 1.1%. As of Thursday’s close, Dow industrials, the S&P 500 and the Nasdaq Composite were up from their mid-June lows by 13.8%, 16.8% and 21.8%, respectively.
At Janus Henderson Investors, which manages just under $300 billion in assets, Jason England, a Newport Beach, Calif.-based global bonds portfolio manager, said that financial-market fears in the first half “were that a recession would be more drawn out or severe.”
“We always felt it would be shallow and not as deep as some had thought. The market was trying to price that in, we were not,” he said via phone. “My team here had the view that nothing really broke. The Great Financial Crisis was about the financial market cracking, COVID was the pandemic. This time around, there are strong company balance sheets and a strong labor market, so we could avoid a severe recession.”
The Absolute Return Income strategies England helps to oversee were positioned for a flattening Treasury curve early on, and are now “tactically adding back duration,” he said. “If rates get to a peak, you benefit by owning duration, which captures additional yield in your portfolio.”
In foreign-exchange markets, the pricing of major currencies like the dollar is still “closely anchored” to stagflation and recession as the most likely outcomes, and the dollar is trading as a “superb” hedge against the risk of high inflation and slower growth, said Mark McCormick, global head of FX strategy for TD Securities in Toronto.
Those risks “have not been fully priced out yet in the dollar” and people are still long the dollar because “a deterioration of growth in Europe and Asia at the same time are powerful forces that the dollar responds to,” he said. Given a more than 13% year-to-date rise in the ICE U.S. Dollar Index /zigman2/quotes/210598269/delayed DXY -0.68% , the greenback “is not priced for a softish landing, it’s priced for a contraction in the global economy and the question is how much the U.S. contributes to that weakness.”
“If things evolve into a better state in the next six months — China recovers, Europe produces fiscal stimulus — and 2023 looks a lot better, the dollar will look very expensive, given its stagflation properties heading into what could be a better world,” McCormick said.
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