Recession Risk Remains

Global equities have continued their recent choppy performance, rising some 2% last week and reversing their drop the previous week. US equities fared best with a gain of 2.4% in sterling terms, while the UK was up 1.1% and emerging markets lagged with a rise of 0.2%. Meanwhile, government bond yields increased a little.

Last week’s stock market gains were fuelled by the latest data releases which showed the US economy continuing to hold up surprisingly well. First quarter growth was revised up to a quarterly annualised 2.0% with consumer spending growing at a strong 4.2% pace.

More importantly, more up-to-date indicators also came in stronger than expected. Jobless claims dropped unexpectedly, consumer confidence rose to its highest level since the start of last year, and new home sales and manufacturers’ orders both picked up in May.

The UK economy is also proving unexpectedly resilient. Consumer sentiment recovered to a 17-month high in June and some retailers such as Next have posted better than expected trading updates. Even house prices confounded forecasts for a fall, edging up 0.1% in June.

This resilience, particularly in the US, has been a major reason along with the AI-related boom in tech stocks, why equity markets have fared better than widely expected so far this year. But it is still too early to cast aside the forecasts of recession heralded by most leading indicators.

The squeeze from the surge in inflation on household real incomes is now easing, albeit much more slowly in the UK than the US, as headline inflation slows as last year’s surge in energy prices drops out.  However, much of the effects of the sharp rise in interest rates still lies ahead, particularly in the UK where mortgagees are more exposed to rising rates than in the US.

Indeed, central bankers at their gathering last week in Portugal did their best to emphasise that they are not yet done with monetary tightening. Fed Chair Powell warned that policy may not yet be sufficiently restrictive and has not been tight for long enough. BOE governor Bailey also said he was sceptical that the peak in rates would be as short-lived as the markets seemed to believe.

As for ECB President Lagarde, she made it clear rates had further to rise in the Eurozone as there was still insufficient evidence that core inflation was stabilising or easing. Friday’s inflation numbers showed the core rate edging up to 5.4% in July.

The market is now pricing in rates rising a further 0.25% to 5.25-5.5% in the US, by an additional 0.5% to 4.0% in the Eurozone and by as much as 1.25% to 6.25% in the UK. Other than in the UK, where considerable uncertainty remains over where rates peak and these forecasts look too high, these estimates look plausible.

Much more uncertain is how fast rates will fall back from their highs. While markets no longer expect the Fed to cut rates later this year, they are anticipating US rates to decline faster than the Fed is forecasting and to be back down to 4% by the end of next year. This only looks plausible if there is a recession.

Herein lies the downside risk for equities. Recession is far from a foregone conclusion but does remain a real risk. However, equity markets seem to be assuming the danger has receded altogether and ignoring the possibility that recession may just have been delayed. In short, this remains the big question for markets – be it bonds or equities – and is still far from resolved one way or the other.

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