Late but live: is a global recession
still on the way?

Just delayed or cancelled outright? The recession forecast by so many for 2023 has stubbornly failed to arrive, begging the question of whether the world’s central banks are managing to engineer a soft landing, or whether the global economy will still contract, only later than forecast?

A downturn remains on the cards, argues Kokou Agbo-Bloua, Head of Economics, Cross-Asset and Quant Research at Societe Generale Corporate and Investment Banking, led by two quarters of negative growth in the US in the first half of 2024. The recession is likely to be mild, but it will come, he believes. Most obviously because the 5 percentage points of monetary tightening undertaken by the Federal Reserve over the past 18 months will hit demand, jobs and confidence – albeit with a lag.

One reason that lag appears so long this cycle is that many large corporations are flush with cash from government pandemic handouts and have locked in long-term financing at very low rates. This has effectively immunised them against rising interest rates, breaking the traditional transmission mechanism whereby higher rates lead, more or less immediately, to demand destruction.

Add in the fact that companies have been able to pass on higher input costs and profit margins are at levels not seen since 2007 (hence the term ‘greedflation’) and it is easy to see why firms have retained employees rather than letting them go – with skill shortages following the ‘great resignation’ being another factor. All this has kept labour markets healthy, consumers confident and happy to spend their excess Covid savings, leading to a stronger-for-longer global economy.

Partial immunity only

Immunity against rising finance costs is, however, mostly restricted to the large corporates featured in the S&P 500 index. For the smaller companies that make up the bulk of employment and GDP, financial conditions have tightened markedly. Their demand and confidence are dropping, as signalled by the recent declines in leading economic indicators in the US, Europe and the UK.

Then there is the drag from China, where the boost from the end of Zero Covid has petered out and deflation is setting in amidst a declining real estate sector, falling investment and rising precautionary savings among consumers. The central government has capacity for a fiscal stimulus but appears committed to austerity to clean up excessive local borrowings.

Finally, what matters most to the global economy is how central banks will act. “Credibility is their main asset”, says Mr Agbo-Bloua, “so they have no choice but to bring inflation back to target.” And in the process, they almost always end up triggering a recession.

Minority report

There is, however, a tempting alternative. The rapid tightening carried out by the Fed and most other major central banks has helped to restore their credibility so that they can make future monetary decisions on the basis of the most recent data and do not need to act hastily. Investors seem relatively relaxed – as shown by the low levels of the VIX volatility index – and prepared to give policymakers the benefit of the doubt.

That means it may be possible for the Fed and its peers to steer the economy to a soft landing, stabilizing at, say, around 2% economic growth, inflation of just over 2% and nominal rates of 4-5%. In these circumstances, unemployment may never need to spike.

There is evidence that we are heading this way, with headline (and, to a lesser extent, core) inflation dropping rapidly in most western countries, while growth and employment have not cratered. “In a sense, this would be a return to the great moderation that preceded the global financial crisis and pandemic”, reasons Hatem Mustapha, Co-Head of Global Markets Activities at Societe Generale. If so, it could presage much milder economic cycles in the future.

Under this scenario, China’s slowdown is actually a positive as it exports a measure of deflation (through commodity prices) and negative growth (via earnings of exposed multinationals) that help the west control excess price growth and asset prices.

A return to productivity growth, which has been inexplicably quiescent, would also help by easing the tight job market and damping wage inflation. Artificial intelligence (AI) has the potential to restart productivity growth, though Mr Agbo-Bloua cautions that it will require significant investment first.

Hedging the alternatives

Faced with two divergent scenarios – though Societe Generale’s investment bank’s main forecast remains a shallow recession early next year – investors need to consider their options carefully. Anyone who invested in bonds this year in the expectation of an imminent downturn is currently nursing losses.

But the short end of the yield curve, including cash offers returns not available for many years. Meanwhile, buying longer maturities is probably best done in tandem with a hedging programme.

For equities, a thematic approach seems sensible: investing in the energy transition, in AI, or indeed in ‘immune’ companies, those with strong balance sheets. That also suggests favouring investment grade corporate bonds over high-yield ones.

By taking a balanced and cautious approach, investors can face the approaching downturn with equanimity, whatever shape it ends up taking.