Going the distance

By Jim Allworth

Until well into 2023 we think the trajectory of the world’s major economies will be shaped by the normal progression of the business cycle and the remaining effects of policies put in place to contend with the pandemic.

Following the shortest recession on record – less than three months – the U.S. economy had regained all its ground by the end of the third quarter of 2021. Canada likely hit that milestone in the fourth quarter.

Our principal focus is always on the U.S. economy – the world’s largest which sets the rhythm and tone for much of the developed world. A U.S. recession has usually been bad news for other economies and for equity markets. Every bear market for U.S. stocks – and for most other equity markets – has been associated with a U.S. recession.

One direction

All six leading indicators of a U.S. recession that we follow are pointing in a direction consistent with this economic expansion having quite a bit further to run. Powerful tailwinds are driving the U.S. economy and most developed economies forward:

• Credit conditions are very “easy.” U.S. recessions, with few exceptions, have been triggered by the arrival of overly tight credit conditions featuring: (1) prohibitively high interest rates that discourage businesses and individuals from borrowing and (2) an unwillingness by banks to lend. The opposite describes today’s credit conditions. Rates are so low they encourage borrowing, while banks everywhere are looking for credit-worthy individuals, businesses, and projects to which to lend.
• U.S. and Canadian households are sitting on excess savings built up over the pandemic of more than 10% of GDP. We expect about 20% of this saving pile will get spent in the coming year or two, and keep the consumer spending engine powering through 2023.
• Inventories of goods on hand are unusually depleted and need to be replenished for many businesses to meet current demand. Restocking should underpin industrial production and GDP growth through much of this year.
• Business capital spending has been strong in the U.S. driven by low interest rates, strong corporate profits, as well as the need for more capacity and more resilient supply chains.

Could the Fed and other central banks spoil the party?

The answer is “Yes – eventually.” But before that happens, monetary conditions have to transition from “easy” – what we have now – all the way to “tight,” which looks far off. And once it finally arrives, “tight money” is typically around for six to 12 months before the U.S. economy tips into recession.

Usually the fed funds rate has had to climb above the nominal growth rate of GDP (i.e., the growth rate before subtracting the effect of price increases) before a recession gets under way. Looked at this way, at the end of last year’s third quarter, U.S. GDP was ahead by 9% over the previous year. The fed funds rate is currently close to zero. Assuming the Fed raises rates three times next year (as it has indicated) and then raises by 0.25% at each meeting thereafter (i.e., far faster than either the Fed or the market currently expect) that would leave the rate at 2.75% by the end of 2023. This is still well short of the nominal GDP run rate, which we expect by then to have slowed to 4%-5%.

In other words, we seem to be a long way from the kind of interest rate environment that would throw the U.S. into recession. It’s worth remembering the Fed doesn’t tighten with the intention of pushing the economy into recession. It is always trying to engineer a “soft landing” wherein the economy slows enough to reduce inflationary pressures but avoids an outright downturn. Of the 17 Fed tightening cycles since 1953, only eight ended in recession.

We expect inflation to ebb in the second half of 2022 and recede further in 2023 under the influence of:

• Resolution of factors that have artificially produced shortages;
• Return of more people to the labourforce as benefit programs end and personal safety issues fade; and
• A capital spending boom already under way yields productivity gains that somewhat offset higher employment costs.

If this proves to be the case, the Fed and other central banks may be able to end rate hikes before credit conditions pass the point of no return for the economy.

Either way, the economic tailwinds described earlier provide good reasons to expect above-trend GDP and corporate profit growth through 2022 and probably 2023 as well. It would be unusual for share prices not to maintain an upward trend for at least another 12-18 months in that case.

Recession Scorecard

What could go wrong?

Our Recession Scorecard persuades us the business cycle is alive and well and has much further to run. It would take some powerful external event or circumstances to produce a sustained downturn from here. There is no shortage of media speculation about what might threaten to do this. For example, the threat of contagion from possible credit defaults within the large Chinese property sector, or a geopolitical flare-up. And the arrival of the Omicron variant reminds us that the pandemic remains capable of seriously disrupting economic momentum.

Such potential threats regularly come on and off the stage and it’s always worth considering what they might mean for the economy and financial markets. But structuring a portfolio as if one or more were likely to occur soon would have left a portfolio un-invested, or at least under-invested, for most of the past 15 years if not longer.

In our view, an investment portfolio diversified across asset classes – where the equity component is diversified sensibly across industry sectors and owns the best, most resilient businesses in each sector – is the most appropriate stance in a world of unpredictable possibilities.

For a more comprehensive look at where we see the global economy and financial markets headed over the next several years ask for a copy of our Global Insight Outlook issue.

Jim Allworth is co-chair of the RBC Global Portfolio Advisory Committee.