The Compendium - The 10 toughest client questions we've fielded

1) Why do we still expect a US recession?

The incoming data for the US YTD has been surprisingly resilient and bolstered hopes of a soft landing. We think that remains unlikely for four main reasons:

• First, the labor market is slowing rapidly and barely generating jobs outside healthcare. Payrolls would turn negative around year end If the trend continues.
• Second, consumption growth is under increasing pressure from tightening lending standards, student loan repayments resuming and excess savings being depleted.
• Third, investment sentiment looks weak and the momentum in non-residential structures is fading.
• Fourth, fiscal drag will continue with expiring consumer support programs (childcare subsidies, food assistance, etc.) and the caps in the debt limit deal. A mild recession would, however, put the economy on a stronger growth footing in 2025 and thereafter.

2) Can equities fall if there is no hard landing?

Equities are too optimistically priced and could fall even without a recession (though clearly a recession would make it more likely). We highlight 4 different approaches to the mispricing: (i) growth rates implied by markets indicate above trend growth rather than the actual subpar growth; (ii) consensus expectations for earnings imply nominal GDP growth that is 2-3 times higher than what we have in the forecast (and which implies flat earnings growth next year); in Europe, margins have barely fallen but could fall 10-20% next year; (iii) using option markets we estimate a recession is 31% priced in the US and 49% in the Eurozone; there is scope for the market to price more even without a hard landing (which would involve probabilities of 85-90%); (iv) using our REVS framework we show that the probability of ‘expansion’ is overpriced given the monetary/fiscal mix. With enterprise resource planning (ERP) historically low there is little room for valuations to offset earnings weakness.

3) What’s the evidence on inflation getting ‘stuck’?

We find little evidence of inflation getting 'stuck'. Prior studies over-sample and rely heavily on the 1970s period (which accounted for over ⅔ of the "stuck" inflation episodes and which in the US context is not a good analogy), history also suggests inflation generally comes down as fast as it has gone up. The current 3-month annualized run-rate for headline and goods inflation is already back at pre-pandemic levels, and core services and services ex-housing are slowing solidly: services are three-fourths of the way back to their pre-pandemic means. Near-term, however, it is possible we see some renewed pick-up due to energy prices and in the US also some seasonality distortion.

4) Are real rates too high or is this the new normal?

Real rates, particularly in the US, look high relative to growth and policy expectations, and forward rates are already more than 130bp higher than the Fed’s latest long-term r-star (i.e. the neutral interest rate) estimate. While supply should drive up term premiums over the medium-term, shorter-term changes in term premia depend much more on demand than supply. Trading purely on supply means taking an enormous amount of cyclical risk to capture a much smaller, slower moving structural trend. The biggest risk to global bond demand is if the correlation between bonds and equities remains positive, reducing the diversification benefits of owning bonds. But history suggests correlations will flip negative again as core CPI moves thorough 2½%. Quantitative tightening (QT) effects hit different markets at different times. We think the majority of US QT is behind us, with UK currently feeling the largest pressures, and the ECB not even starting PEPP runoff until the Fed has completed QT.

5) Are labor markets showing signs of cracks?

Employment growth is slowing sharply globally, and vacancy rates are falling (and faster in the US then elsewhere, albeit from higher levels). This is now starting to push up unemployment, but only barely. In level terms, labor markets remain historically tight. Three quarters of countries have unemployment running below pre-pandemic levels, and in only a handful have vacancy/unemployment ratios slipped back below Q4-19 levels. The manufacturing economies in Europe have been surprisingly resilient given the global trade/manufacturing weakness (still reported labor shortages in manufacturing) but this could be a (fading) backlog story. In the US, momentum is negative, important reopening sectors have stopped hiring, and further profit pressure could presage layoffs. But the data remains too mixed (e.g. claims recently improved) to assert with confidence that the labor market will 'crack'.

6) Why isn't China's slowdown impacting the rest of the world more?

Outside of China assets themselves, spillovers to global markets from slowing China growth have been remarkably muted thus far. Import volumes have been surprisingly strong (and energy imports supported by a strong recovery in mobility), capital flight has been limited, and infrastructure and manufacturing capex have been an increasingly large offset to real estate (though are now also likely to slow). We remain concerned that import weakness could become more pronounced, which we see weighing mainly on other EM currencies.

7) How contractionary is fiscal policy next year?

Fiscal stimulus has helped stave off recession in several economies but also slowed the pace of disinflation. We estimate the fiscal drag next year remains modest, falling from 0.75% of global GDP to 0.25% GDP. Most of that step-down is diminished drag from the US; controlling for that, the average country adjustment (0.4% GDP) is similar in '23 and '24. Despite the underlying improvement in fiscal positions, headline deficits have failed to recede, primarily due to weakness in the business cycle, higher debt service (due to higher rates) and reduced profit transfers from central banks. The US is an outlier in having seen its improvement in the cyclically adjusted primary fully offset by one-offs and cyclical deterioration this year. That suggests things are maybe not as bad as the headline suggests, but net interest payments increase further to 3% GDP next year. We project 8 economies to undertake more than 1% GDP adjustment next year. The projected fiscal drag from the US and Eurozone is roughly the same (0.4% GDP) and looks too small to materially impact growth and inflation.

8) Where are we in the global inventory cycle?

Global inventory growth has stalled, both in the national accounts and PMI data. However, in level terms, inventories have barely started to decline (though in the US intermediate inventories are roughly back to where they were at the start of the pandemic, while globally they sit more than a standard deviation above pre-pandemic levels). Finished goods inventories are still rising. We take little signal from inventories as in contrast to orders they tend to be a lagging indicator and cannot predict GDP or investment in the coming quarter once you control for the inertial move in those variables themselves. Inventories do correlate strongly with recessions but only contemporaneously so. Currently they mainly tell us that demand is weak, but little else.

9) What does monetary regime change in Japan imply?

The path to policy normalization is uncertain given uncertainty over sustaining current wage momentum. We expect that a BoJ exit involves first dropping the negative interest rate policy (NIRP) and then yield curve control (YCC), and for the overnight rate to eventually be raised to 1-1.5% (with 10-year yields climbing to 1.5%). Stocks would remain well supported in this stronger consumption environment, but USD/JPY could retrench to 120 as real rate spreads vs the US narrow. Japanese institutions won't be big sellers of assets in foreign markets. Fiscal sensitivities will increase sharply, likely exceeding levels last seen in the 1990s.

10) High for longer or ‘restrictive’ for longer – are central banks pursuing different exit strategies?

"High for longer" is not the same as "restrictive for longer". Maintaining nominal policy rates flat during the 'pause' already implies a significant increase in real rates, but doing so through the forecast horizon entails an implausible amount of additional tightening given the weak state of the economy. We expect the first Fed cut when the real policy rate reaches nearly 3% in March (above the 2.5% average in 2024 in the dot plot); the first BoE and ECB cut in May and June, respectively, when the real policy rate reaches 1.2% in both countries; the SNB to start cutting when the real rate is barely positive (given their reliance on FX) and the RBA to start cutting at a real rates level that is less restrictive than in the UK/Eurozone/US.