Market Watch: Recession risk builds as world waits for inflation peak

“Recession risks continue to grow,” says Pie Funds chief executive Mike Taylor. “They’ve been building throughout the year. What’s been surprising is that the [economy] has been as strong as it has been. It has taken a significant number of interest rate hikes to put the brakes on economies, both here and around the world.”

In fact, there were still some signs of real resilience in the economy which suggested we should expect rates to keep rising for a while, Taylor said.

“We do need to step back and recognise that when you raise rates it does take about six months to have an impact on the real economy. We won’t really know how the economy is doing until March next year.

“But at this point, it does look like things are slowing down, which is indicating we are headed for a recession at the beginning of next year.”

Markets whipsawed again this week after the latest rate call by the US Federal Reserve failed to provide more certainty about where interest rates will peak.

The US Fed delivered another big 75 basis point rate hike on Thursday morning and hinted that it may be near the peak of this rate hike cycle. Wall Street rallied and markets rose.

But within minutes US Fed chair Jerome Powell had reversed the sentiment by talking up the prospect that more big hikes will be needed to beat inflation.

“It is very premature to think about pausing,” Powell said. “We have a ways to go. I would want people to understand our commitment to getting this done.”

Those comments saw markets plunge with the S&P 500 shedding 2.5 per cent, having been up 1 per cent earlier.

Markets continued to be far more focused on the outlook from the Fed than they were on corporate earnings, Taylor said.

“If we can get an outcome where the Fed indicates it has done enough - even if earnings look quite negative next year - that might be enough for the market to breathe a sigh of relief.”

That would certainly be a welcome relief for investors with 2022 so far being one of the worst on record for financial market returns.

In historical context, 2022 has been the worst year on record for bond investors, thanks to the rapid acceleration of interest rates, Taylor said.

“If you’re a bond investor it’s been disastrous.”

In terms of equities 2022 had been one of the bottom five in terms of performance, he said.

“The reason it hasn’t felt so bad is that we haven’t really had a crash or anything like that to grab headlines, like in the past with 1987 or the Lehman collapse in 2008.

“What we’ve seen this year is that everybody has been well aware of the problem, we’ve been through a pandemic, we’ve had high inflation and investors have adjusted to that throughout the year in a relatively calm way.

“There hasn’t been too much panic through the markets.”

But this had been the fastest acceleration of interest rates on record and there was no way to know what the impact will be in the next six or 12 months.

“We can only surmise and best guess is to say that economy will slow quite markedly in 2023.”

The good news was that, even though a peak wasn’t yet certain, US inflation hasn’t had a higher print since June of this year, he said.

“So we are looking for lower prints in the [inflation data] but don’t expect the Fed to just pause or cut. They have indicated that the target is to get [inflation] back to 2 per cent. So in the absence of a financial shock, I would expect them to reach a point where they are comfortable and then just hold rates there until inflation really falls through the floor.”

- The Market Watch video show is produced with support from Pie Funds.