Are we heading for a recession?

By Jayson Forrest - Managing Editor  - IMAP Perspectives

Recession’ is a word that is increasingly gaining prominence in both news headlines and in many adviser/client conversations. Diana Mousina (AMP Capital) and David Matesic (Atrium Investment Management) recently joined together to discuss whether Australia is heading towards a recession and how portfolios should be positioned in response.

Are we heading for a recession?’ - that’s the million dollar question many advisers struggle to answer when discussing this topic with their clients.

The Federal Reserve Chair, Jerome Powell has acknowledged that a U.S. recession is a possibility, but not necessarily inevitable. While back at home, many economists are hedging their bets, saying there is a 50 per cent chance of Australia falling into recession next year, pointing to higher interest rates, a reduced tolerance for larger budget deficits, and slower global growth.

However, it’s not a view supported by Diana Mousina - a Senior Economist at AMP Capital.

Speaking at an IMAP webinar on ‘Are we heading for a recession?’, Diana believes when considering the likelihood of a recession, it’s important to look at the Purchasing Managers’ Index (PMI) - an index of the prevailing direction of economic trends in the manufacturing and service sectors - as s guide to measuring global growth.

In the U.S., the PMI reveals a contraction in activity in the services sector, which is to be expected, considering the increase in interest rates by the Fed over the last few months. Whereas in Europe, a lot of that contraction has occurred in the manufacturing sector, which is being impacted by high inflation, particularly by the price of gas.

“We’re due for a slowing in global growth, which will continue to happen in the second half of 2022,” says Diana. “But the question is, will that slowing of global growth be significant enough to cause economies to go into recession?”

Diana believes the key indicators so far suggest the global economy will probably avoid a recession, but she adds that not all countries will be immune to recession.

“We believe the U.S. has the highest chance - about 50 per cent - of going into recession over the next 12-24 months, while Europe will most likely experience very low growth and probably avoid a recession, because interest rates haven’t risen as much in Europe as they have in the United States,” says Diana. “The PMI data is telling us that global activity is likely to slow.”   

Like Europe, Diana believes there is less chance of Australia heading into recession. And while she accepts that the risks of a recession have risen on the back of the rise in interest rates, it’s a base case for Australia that AMP Capital is not expecting. The manager bases this assumption on the belief that the RBA will not be able to hike interest rates as high as the market is currently pricing in, and also because Australia continues to benefit from strong commodity prices, which is keeping the country’s net export sector ticking over.

“For Australia, we’re expecting a slow down in growth. We believe GDP growth will slow to about 2.7 per cent year-on-year to December 2022, and 2.2 per cent year-on-year to December 2023. That’s quite significant slowing on the current pace of growth, and we also expect that inflation will probably remain quite elevated at between 3-4 per cent next year. These outcomes are consistent with a stagflation environment, which is not positive for risk or growth assets. So, there are reasons for caution with equity markets next year.”

When it comes to inflation, Diana says the big difference between what’s happening in Australia and the United States comes down to wages growth. While the U.S. labour market hasn’t tightened as much as Australia, it has had much stronger wages growth.

“In Australia, we haven’t had the same pick up in wages growth, despite a very tight labour market and the unemployment rate sitting at a 48-year low,” says Diana. “Australia’s nominal wages growth is only running at 2.4 per cent on an annual basis. However, we do expect wages to pick up and get to about 3.5 per cent next year, but still not as high as in the United States.

“That means there won’t be as much flowing through into inflation because wage costs are about 70 per cent of a business’s overall costs. That’s probably a good thing, because both inflation and wages drive each other. If you have high wages inflation, then that does tend to drive higher overall CPI outcomes, as well.”

According to Diana, AMP Capital expects inflation in Australia to peak at about 7.5 per cent by the end of this year, while in the U.S., the headline inflation figure will be closer to 9 per cent.

“Arguably, the U.S. has a worse inflation problem, which is the result of more fiscal stimulus being applied last year compared to Australia. Most of our COVID stimulus was done in 2020, when we had JobKeeper payments, and not as much stimulus was done last year.”

However, despite these high inflation figures, AMP Capital is expecting inflation to begin slowing globally, with commodity prices already showing signs of a deceleration, apart from gas - which continues to be heavily impacted by the restrictions around supply due to the Ukraine/Russia conflict. As Diana says: “You want to see falling commodity prices to get inflation down.”

However, despite falling commodity prices, interest rates around the world will continue to head higher, at least until the second half of next year, when Diana predicts that the Fed and RBA will begin to cut interest rates.

AMP Capital remains reasonably bullish on the cash rate, expecting the RBA to lift the cash rate to 2.6 per cent, but not much higher than that. This figure is considerably lower than future market pricing, which is generally about 4 per cent.

“A cash rate of about 2.6 per cent is sustainable for most Australian households, but once you get to a cash rate of about 3 per cent, you will see significant stress in Australian households, particularly with paying off mortgages,” says Diana.

According to Diana, the RBA already estimates that increases in interest rates will mean that 38 per cent of households with a mortgage will face an increase in their monthly repayments of 40 per cent or more, which presents serious risks to Australian spending. This will also lead to a reduction in house prices, which are expected to drop in Australia by about 15-20 per cent (from their peak) into the second half of next year.

“We understand the market is pricing in a cash rate of about 4 per cent, but we don’t see how a cash rate of 4 per cent in Australia won’t create a recession, and that’s something the RBA wants to avoid,” says Diana. “Even if we get to a 3.5 per cent cash rate, that would still be a significant risk for tipping us into a recession.”

Against this backdrop of higher interest rates and an inflationary environment, Diana believes advisers and investors need to carefully manage their investment portfolios. She offers the following views on six major asset classes:

* Cash - offers very poor returns, but it’s improving with interest rate hikes;

* Bonds - may see some return improvement, as the rise in bond yields pauses;

* Equities - expect more near term downside, but reasonable single digit returns on a 12-month horizon;

* Residential property - house prices are likely to fall by 15-20 per cent into 2023, as poor affordability and rising interest rates impact the sector, but with wide variation between regions;

* Unlisted commercial property and infrastructure – hit hard from work-from-home, online retail and less travel, but there remains strong investor demand; and

* Australian dollar - likely to remain weak with shares in the near term, but should see a rising trend on a 12-month view, as commodity prices remain strong.

While sharing many of these views of the major asset classes, David Matesic CFA - a Portfolio Manager at Atrium Investment Management - reveals the manager remains defensively positioned.

“Our equity allocations are probably towards the lower end of our range. We see equities facing a number of headwinds, like rising interest rates, inflation, and quantitative tightening. And so, we have reduced our equity exposure across all our portfolios. But within that space, we maintain a bias towards quality companies that we think will probably perform much better in this type of environment,” says David.

Turning to bonds, Atrium has historically been quite underweight bonds, but it has started to dip its toe back into the water. “The Australian 10-year nominal bond briefly touched 4 per cent about one month ago, so we saw that as a relatively good entry point. But overall, we remain quite tentative with allocating to bonds.”  

Credit is an area that Atrium is seeing a lot of opportunities in. Credit markets have been sold down quite heavily, presenting many opportunities for investors. And alternatives, says David, are also extremely well positioned in this current environment of elevated volatility and dispersion.  

Given that AMP Capital is expecting a recession in the U.S. sometime over the next two years, and with Australia likely to avoid recession, considering this scenario, does Diana prefer to be more overweight Aussie equities versus global equities?

“I would say, yes,” she says. “We are more optimistic on Aussie equities compared to U.S. equities. Generally, a high inflation, high bond yield environment is not as positive for tech stocks, which the U.S. has a high weighting to. About 40 per cent of the S&P Index is comprised of tech and consumer discretionary stocks.

“Whereas in Australia, we have a higher exposure to commodities and banks. We believe commodities will remain quite elevated for some time, which will be positive for Australia’s national income and our index. So, if the U.S. does go into recession, we are confident that Australian shares can outperform.”

Diana Mousina is a Senior Economist at AMP Capital; and

David Matesic CFA is a Portfolio Manager at Atrium Investment Management.

They spoke on the topic ‘Are we heading for a recession?’ at an IMAP webinar.