Higher prices for everything, from weekly groceries to mortgages, are straining consumers’ wallets and represent a significant risk for US households. The economy hasn’t yet absorbed the full impact of the US Federal Reserve’s interest rate hikes and higher credit costs. It typically takes 18 months, on average, for rate hikes to fully affect consumer and business activity.
History, too, demonstrates the US economy typically responds to bouts of central bank tightening with economic recession. The Fed has undertaken 12 tightening cycles in the last 63 years. Of those tightening cycles, only four ended in soft landings, while the remaining eight ended in recession.
Importantly, when soft-landings did arise, the economic conditions had little in common with the economic times today. Unlike prior periods, inflation is much higher and lending standards are much stricter, which will act as impediments to economic growth.
When soft landings did result after rate rises, they followed modest rate increases and no inflation spikes. The current economic cycle is different. The US Fed has raised rates relatively quickly, by 5.25 percentage points from March 2022 through to July 2023. Additionally, inflation peaked at 9.1 per cent in June 2022, well above historical rates of inflation.
Combining these factors, recession is the most likely outcome rather than a soft landing. Additionally, inflation remains well above the Fed’s 2 per cent annual target, though it has dropped from its 9.1 per cent peak. Still, consumer prices have been rising for nearly three years and that is taking a toll on households. Between January 2021 and September 2023, headline inflation rose nearly 18 per cent.
Against these price pressures, the Fed recently reported that consumers have depleted their excess savings. So, we are likely to see consumer spending slow down markedly.
Meanwhile, car and mortgage loan rates have soared to multi-year highs, while prices for cars and homes have continued to climb. Also, a student loan repayment-freeze recently expired, which will result in higher monthly payment obligations for 27 million federal student loan holders. Accordingly, many of them are expected to cut back on spending.
More broadly, these financial burdens will weigh on corporate profits and drag down consumer spending, which accounts for approximately 70 per cent of gross domestic product (GDP).
For these reasons, the odds of recession are sharply higher than the chances of a “Goldilocks” soft-landing scenario or stagflation. The risk of recession is likely to remain relatively high over the next six months; inflation is likely to linger at 3 per cent or higher. Eventually, GDP is likely to contract, ultimately triggering rate cuts from the Fed, which should ease pressure on households.
So, just what does a recession mean for investors?
If recession does set in, yields on US Treasuries are likely to fall and credit spreads may widen. We believe in investing in higher quality and more defensive assets as the economy weakens.
Within fixed income allocations, we believe in increasing bond duration exposure. Diversified strategies with longer durations may potentially offer performance advantages as interest rates decline. A modest allocation to high-quality investment grade credit may provide more attractive yields, in addition to delivering diversification to investor portfolios. However, credit selection is critical to avoid weaker, overly recession-sensitive issuers.
In terms of equity allocations, we favour target quality stocks. Quality companies with higher profitability and healthy balance sheets may offer attractive potential. Investors tend to favour quality companies in more defensive sectors, such as utilities, healthcare, and consumer staples. Companies with dependable, secular earnings growth have tended to outperform during economic downturns. Additionally, dividend-paying stocks look attractive for the income levels they have historically provided. Economically sensitive value sectors, such as financials, industrials and energy, have tended to lag alongside lowered growth expectations.
Less emphasis should be placed on style distinctions. Historically, there has been no clear winner when it comes to growth versus value investing during recessions. Growth beat value on a total return basis in five of the last eight recessions. However, the average maximum drawdown over those periods slightly favoured value stocks, based on our analysis of index returns.
It would also be wise to tread carefully in commodities markets. As consumer and industrial demand wanes, commodities typically lose their lustre. However, gold may continue to shine amid falling interest rates and heightened economic and market uncertainty.
Victor Zhang, chief investment officer, American Century Investments
