The “R” word: What Powell and markets are telling us

July 31, 2022

David Bailin

Chief Investment Officer and Head of Citi Global Wealth Investments

Steven Wieting

Chief Investment Strategist and Chief Economist

SUMMARY

Many argue that financial markets now price in a recession. We disagree. In our view, markets do not price in a collapse in the economy or corporate profits. For markets to “stay in the black” from here, a true recession – one with net US job losses measured in millions - would best be avoided.

Whatever the semantics over the term “recession,” observers should be more concerned about the outlook for both labor markets and corporate profits beyond the slowing that has already transpired.
The US Federal Reserve is beginning to see signs that the economy is more vulnerable, and therefore may be less brash in calibrating policy than its more recent highly confident views suggested. This alone reduces some of the risk of a severe recession.
And just to make things more complex, we think GDP could turn positive as inflation cools in Q3 2022. Though jobless claims will rise, there is likely to still be net job creation, higher wages and sustained consumer spending, albeit at very modest levels. We also expect price declines at the retail level for many discretionary consumer goods that have now been stockpiled.
At our last Global Investment Committee meeting, we raised our US bond overweight to nearly 10% in medium risk global portfolios. We did not underweight quality equities, however. We severely underweighted Japanese and European bonds instead.
We believe equity markets have discounted higher interest rates, but have not adequately discounted severe weakness in cyclical industries apart from discretionary consumer spending. We are therefore emphasizing ownership of equities in non-cyclical industries and those with extremely high credit quality.
Eventually, the extremes of any business cycle weakening will mean recovery for the most beaten down components in a new or “refreshed” business cycle recovery. We would not, however, want to jump to the conclusion that this is already underway. We look forward to taking greater portfolio risk when conditions are right.