Introduction

Recession discussions, interest rate hikes, economic consequences of the war: Key events of the third quarter?

• In the last quarter, monetary tightening and recession discussions, which have been the main agenda throughout the year, remained on the agenda. In particular, the policies of the US Federal Reserve were the most important factor affecting the markets in this quarter. With the hope that the Fed will step back from its tight monetary policy, markets have recovered from the lows of mid-June. However, hawkish messages from the Fed officials since mid-August and the signals given at the Fed meeting that the stance would continue, caused a new selling wave in the markets.


• Looking at the current outlook, economists, strategists and fund managers see a 50-60% chance of the US economy entering recession in the next 12 months, according to various market surveys (over 70% probability for the European economy). Professor Steve Hanke of Johns Hopkins University predicts a much higher 80% probability of the US economy going into recession within 12 months. Hanke states that the reason for this is that M2 money supply growth turned negative with the rapid withdrawal of liquidity following the extreme monetary expansion in 2020.


• In this report, we reviewed the latest status of some macro indicators that stood out as reliable recession indicators in the past and evaluated what might happen in the global economy and markets in the upcoming period. The aforementioned indicators can be summarized as the interest increase rate of the FED, the shape of the yield curve, consumer confidence, the unemployment rate, and especially the level and change of oil prices. On the other hand, we shared the latest developments in the energy, metal and food sectors that stood out in the last quarter and our expectations for the upcoming period.


• In the upcoming period, we think that the mutual sanctions between the USA – EU and Russia due to the Ukraine war may continue, which will keep the upward risks on energy and food commodity prices hold high. Considering the upside risks related to tension between Russia and Ukraine, we expect that the price of Brent oil per barrel will be around $95 by the end of the year. We expect the FED to maintain its inflation-oriented monetary policy stance and to keep the policy rate high until at least the end of 2023. Last but not least, we assume that vaccines will remain effective despite virus mutations from Covid-19.


• Latest FOMC meeting on 21 September altered the investment sentiment significantly, as the FED clearly indicated that it intends to keep the policy rate at higher and longer than previously expected (desired) by markets. Remembering that the FED's forecast for December 2021 was 0.9%, the tightening in the monetary policy stance of the FED since the beginning of the year is more clearly understood.


• FED’s aggressive tightening cycle, along with the ongoing implications of the Russia/Ukraine war (potential pressure on commodity prices, natural gas in particular) and China’s souring economic outlook have significantly increased the recession expectations, in the U.S. and worldwide.


• In particular, a potential resurgence of oil prices (e.g. towards USD100bbl levels) due to external and geopolitical factors has the potential to drag the U.S. and World economy into a recessionary or actually a stagflationary era, similar to the one in the 1970s (though to a lesser extent). This would surely have significant implications for the general risk sentiment and economic conditions, borrowing costs of the indebted (EM) economies, in particular.


• Examining the bear markets of the S&P 500 that took place since 1970, we see that the average loss throughout recessionary periods approached roughly 33%. Accordingly, historical data suggests that there may be a lot of room (about 15-20%) for further declines in the US stock markets in the days ahead (barring short-term corrections). The downtrend may actually strengthen in case of an energy price-driven recession. Yet, past experience also shows that the recovery may be very fast from the bottom levels. Accordingly, we may also witness a rapid rise in the S&P-500 index, if central banks soften their stances as the signs of recession become more evident. In this respect, the course of energy prices will be critical, in our view.

Economic Outlook: Global

Despite partial pullbacks in energy and commodity prices, global inflation continues to hover above expectations and close to peak levels.

• Although the CPI inflation retreated to 8.3% in August after peaking at 9.1% in June, surpassed market expectations, and core CPI inflation increased to 6.3% from 5.9%. As a result, rate hike expectations from the FED shifted higher along with hawkish messages from FED officials.


• Since the 1950s, the US economy has tipped into a recession within two years every time inflation has exceeded 4%. This is due to the fact that high inflation forces the FED to implement an aggressive rate hike cycle (bringing the policy rate above the neutral rate), causing a recession and a sharply higher unemployment rate.


• CPI inflation in the Eurozone in Europe rose to its highest level (4-5 times its historical average) since the transition to the Euro, most particularly due to the dramatic rise in energy costs.

FED consistently upgraded its policy rate projections in recent FOMC meetings

• The FED revised its policy rate projections to 4.4% from 3.4% for the end of 2022 and to 4.6% from 3.8% for 2023 at its last FOMC meeting on September 21. Recall that the FED's such projections for December 2021 were 0.9% and 1.6%, which indicates the significant evolution of the FED’s monetary policy stance.


• FED now predicts the core inflation indicator (core PCE) at 4.5%, which was predicted as 2.7% at the end of 2021, now predicts 4.5%. The forecast for 2023, on the other hand, increased from 2.3% to 3.1% over the same period.


• The FED in its latest FOMC meeting also reduced its 2022 GDP growth forecast to as low as 0.2%. Note that this was as high as 4.0% at the last meeting of 2021. The Fed expects the US economy to grow by 1.2% in 2023.


• The Fed expects the unemployment rate, which is currently at a low of 3.5%, to peak at 4.4% in 2023.

Global GDP growth projections are being revised down as central banks further tighten monetary policy

• In its Economic Outlook report published in September, the OECD kept its global growth forecast for 2022 constant at 3.0%, while lowering its 2023 forecast to 2.2% from 2.8% in June and down from 3.2% back in December 2021. Although the OECD kept its 2022 Global growth forecast constant, it significantly lowered its forecasts for the US economy and the Chinese economy. The OECD now projects the U.S. growth for 2022 as 1.5%, down from 2.5% and 3.7% in the prior reports, while China's growth forecast was revised from 5.1% to 4.4% and then to 3.2%. OECD’s 2023 growth forecasts for the U.S. and Eurozone stand at 0.5% each.


• The IMF, on the other hand, kept its Global growth forecast constant at 3.2% for 2022 in its October World Economic Outlook report, while lowering it to 2.7% from 2.9% for 2023. The IMF's 2023 US growth forecast is 1.0%, while the Eurozone growth forecast is 0.5%.

History suggests a so-called “soft landing” is a rare outcome after FED’s monetary tightening cycles

• History suggests a so-called “soft landing” is a rare outcome after FED’s monetary tightening cycles. According to New York Federal Reserve, 11 out of 15 previous tightening cycles (since 1955) have ended up with recessions. Looking at the period after 1970, FED initiated a monetary tightening cycle 10 times, 7 of which have resulted in recession (although all recessions may not be necessarily related to purely FED’s tightening). Although, FED’s monetary tightening cycles have often led to a recession, please note that the period between the start of the tightening and start of the recession varies significantly, ranging from 10 months to 50 months.


• All recessions since the 1960s have been preceded by an inverted yield curve. Yet, its reliability significantly weakens for predicting the timing of the potential recession, as yield curve may actually remain inverted for too long before the economy heads into recession. For instance, we see that ahead of the 1970 recession, the yield curve has actually remained inverted for some 1,456 days (about 4 years) before the economy dipped into recession. Looking at more recent history, the yield curve had been inverted by 670 days (almost 2 years) ahead of the 2008-09 Global Financial Crisis. In the previous 9 recessions, the average timespan between yield curve inversions and recessions has been 592 days (about 1.5 years), although the duration varied between 239 days and 1,456 days. Note that the current yield curve inversion has been ongoing for the past 3 months (since 06 Jul).

All recessions have actually occurred right after the unemployment rate (UR) dipped

• The difference between the two components of the consumer confidence index (released by the Conference Board), namely the «expectations index» and the «present situation index» has been hovering around historically low levels for some time, which has also been a reliable recession precursor in recent history.


• Unemployment rate (UR) has actually been a «lagging» not a «leading» indicator of a recession. Yet, it may still be a reliable precursor for recession, as UR has always been close to its trough level right before the start of the recession. Since the 1950s, the US economy has tipped into a recession within two years every time UR has fallen below 5%.


• The «Sahm Rule» signals the start of a recession when the 3-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months. Accordingly, it can be argued that currently, the historically low levels of UR may not be a relieving factor against recession. On the contrary, it could be a harbinger of an impending recession.

Oil price spikes have preceded seven of the past nine US recessions

• Looking at oil prices in real terms, i.e., adjusted for the US CPI inflation, although the current levels of oil prices are significantly high, they still remain well below the levels witnessed during the 1979 Oil Crisis, 2009 Global Financial Crisis (GFC) and post-GFC recovery period. The resurgence of oil prices (e.g. towards USD100bbl levels) due to external and geopolitical factors has the potential to drag the U.S. and World economy into recessionary or a stagflationary era, similar to the one in the 1970s (though to a lesser extent). This would surely have significant implications for the general risk sentiment and economic conditions, borrowing costs of the indebted (EM) economies, in particular.


• Apart from the price level, oil price shocks (the level change from the previous one or two years) also do matter, as oil price spikes have preceded seven of the past nine US recessions. In that stance, the doubling of global crude oil prices over the past year may be a cause for concern for the probability of a recession. Despite the recent pullback in oil prices from peak levels, its sustainability remains unclear, as we think that the potential for oil prices to rise again due to the ongoing Russia-Ukraine war is maintained.

Historical data suggests that there may be a lot of room (about 15-20%) for further declines in the US stock markets

• The S&P 500 index recently tested new trough levels although it had recovered by about 17% from mid-June to mid-August. The index is currently about 25% below the peak level achieved just at the beginning of the year. This suggests that the S&P index is still hovering at a bear market.


• Examining the bear markets of the S&P 500 that took place since 1970, we see that downtrends lasted for an average of about 8 months, and the average loss throughout these periods approached roughly 30%. Yet, the magnitude and the duration of downtrends are more severe amidst recessionary periods with an average duration of 278 days and an average loss of 33%, while these are 161 days and -23% for non-recessionary periods. Accordingly, historical data suggests that there may be a lot of room (about 15-20%) for further declines in the US stock markets in the days ahead, barring short-term corrections (although we think that each period should be evaluated on its own terms). The downtrend may actually strengthen in case of an energy price-driven recession. For instance, during the 1973-74 oil price shock, the total sell-off in the S&P-500 index reached about 48% in a time span of about 630 days


• All these being said, past experience also shows that the recovery may be very fast from the bottom levels. Accordingly, we may also witness a rapid rise in the S&P-500, if central banks soften their stances as the signs of recession become more evident. In this respect, the course of energy prices will be critical, in our view.