by Brad Tank, Chief Investment Officer—Fixed Income, Neuberger Berman
Neuberger Berman’s Asset Allocation Committee has been far from the most bearish voice on the Street over the past 12 months, but neither have we been enthusiastic about risky assets.
Upgrading our view on equities in our most recent Outlook, we were careful to note that we were still only neutral. We also characterized the move as a short-term measure, one of healthy respect for a market that seemed intent on diverging from the weak economic fundamentals that we had accurately predicted.
Since then, U.S. inflation has fallen to 3% and its GDP growth rate has settled at well above 2%. The International Monetary Fund has upgraded its global GDP growth outlook for this year to 3%. Unemployment remains low almost everywhere. Bond market volatility has come down, equity markets have gone up. And last week, the heads of the U.S. and European central banks put in what may be their last, “just-in-case” rate hikes for the cycle, with zero drama and softball questions from the world’s press.
How did one of the most widely forecast recessions in history fail to happen? And is it possible that it’s still just around the corner?
Lack of Synchronicity
It’s likely that a lot of this surprise comes down to the sheer uniqueness of the post-COVID environment and its economic slowdown. One can think of this uniqueness in two senses: the lack of synchronicity across the global economy, and the fiscal and monetary policy backdrop.
We can see a lack of synchronicity between economies and also within them.
Germany is in mild recession, but the rest of Europe’s large economies are ticking over. The U.S. and Japan are exceeding expectations, China is disappointing them.
Much of the developed world is nearing the peak of a large and rapid rise in interest rates, and experiencing gradual disinflation—except Japan, where policy remains accommodative despite inflation apparently being stuck above 3%. By contrast, much of the emerging world was at this stage of the cycle a year ago, and China is now mulling stimulus as it flirts with deflation.
Within economies, we have seen extraordinarily divergent performance from manufacturing and services sectors.
The S&P Global U.S. Services Purchasing Managers’ Index (PMI) surged into expansion this year, adding jobs and inflation to the economy, while Manufacturing PMI has been unable to get out of contraction. We’ve seen the same divergence in China, Japan and Europe, and it has been especially marked in the latter region.
In aggregate, this lack of synchronicity appears to have resulted in subdued economic volatility. The good and the bad have largely cancelled one another out.
Policy
When it comes to policy, most would agree that the unprecedented fiscal response to the pandemic fanned the flames of inflation in 2022, while acknowledging that its persistent effects have been a tailwind for slowing economies during 2023.
On monetary policy, we came into 2023 concerned about the disruptive potential of such a rapid adjustment in rates. After the second-, third- and fourth-biggest bank failures in U.S. history, one can hardly say it hasn’t been disruptive—but the disruption has been remarkably contained.
Decisive policy responses take some of the credit, but it is also increasingly clear that services-driven economies are more resilient to inflation-busting rate hikes than goods-driven economies. Many economies where rates have been rising also happen to be oriented to services (the U.S., the U.K., much of Europe); those where rates have held steady or come down are often goods-oriented (Japan, China, the emerging world). The going is tough, however, in the few places where a manufacturing economy has been hit by rising rates (Germany).
Housing markets have also proven surprisingly resilient to rising rates. Activity, whether it be new home sales or construction, has slowed, but pricing has been very mixed, region-by-region and country-by-country. Data for May, released last week, indicates that, in aggregate, U.S. house prices are now growing at their fastest pace in a year. Supply-and-demand, complicated by the fluctuating post-COVID dynamics of hybrid and home working, often seems to trump the effect of higher mortgage rates.
Moreover, while a return to more “normal” interest rates after such a prolonged period of cheap money is bound to be disruptive, it is not bad news for everyone. Savers and retired consumers benefit, and they will feel those benefits even more as inflation eases. That helps explain why U.S. consumer confidence and sentiment surveys reveal the highest optimism in two years. Higher rates should be good for banks, insurance companies and other financial firms, too, once the yield curve comes out of inversion.
The interaction of fiscal and monetary policy is also important. Manufacturing-led fiscal and industrial policies lend a helping hand to those sectors most affected by higher rates, while not generating excessive inflation in services. Some call this working at cross purposes. A more sympathetic observer would note that it helps to soften the economic landing.
Dangers
Perhaps, after the deepest yield-curve inversion in living memory, everything is going to turn out OK.
There are still dangers ahead.
Geopolitical tensions remain high, not least between the U.S. and China, the world’s two biggest economies. A war still rages on the edge of Europe—and, as shown by last week’s pop in food and energy prices following attacks on Ukraine’s Danube ports, it could still cause a new wave of inflation. Those fiscal tailwinds will begin to weaken and, in some cases, such as the reintroduction of U.S. student loan repayments, turn to into headwinds.
Investors should also note the jolt of volatility that greeted last week’s tweak to the Bank of Japan’s yield-curve policy: It suggests that any worsening of inflation there, which could pair Japan with Germany as a major manufacturing economy facing rate hikes, remains a considerable tail risk.
But there is cautious optimism in the air. The economists at the Federal Reserve are not the only ones taking a recession out of their forecasts.
