Written by John Muth, macro strategist at Cohen & Steers
When GDP numbers were released for the second quarter, they confirmed what we have known for some time. Economic growth is slowing.
Much of the focus has been on the semantics of whether we are in a recession or not, but that’s not our primary focus. Regardless of the label, it is clear growth is decelerating, though it is against a backdrop of jobs numbers that remain resilient.
Most recently, consumer and corporate spending, which have to date been viewed as economic strengths, have slowed too. Real incomes are also falling as pandemic stimulus wears off. These are significant shifts.
We believe we have arrived at a pivot point. Markets rapidly moved from wondering if and how the U.S. Federal Reserve will respond to rein inflation in to questioning whether the economy can handle the Fed’s response.
Our base case is that we are entering what can be deemed an average recession, as measured against previous recessionary periods. An “average” recession would imply a shallow drop—a decrease of approximately 2–3% in real GDP—and a duration of about 12 months.
That’s a base case, and there is much that can vary from here.
Our clients, according to a recent survey we conducted, are anticipating a mild recession. While 89% respondents to our survey (1) believe that the U.S. will enter a recession, 68% expect it to be mild, while 21% anticipate an average recession. No respondents indicated they felt it would be severe.
We think a softer landing for markets and the economy can be achieved if global supply chains recover, if commodity prices moderate (especially if the war in Ukraine deescalates), and if wage growth moderates if labour force participation rises. On the other hand, if high inflation remains entrenched— and especially if wage prices begin to spiral—central banks will likely push markets to a harder landing through demand moderation (in the form of higher rates).
Volatility is likely to remain elevated in the months ahead as markets discern whether we’re in for a hard or soft landing. In general, our portfolio managers are focused on positioning defensively as well as the capturing opportunities likely created in the dislocations and more recent pullbacks in many asset classes. We are experienced managers and have seen economic slowdowns and bear markets before.
With that experience as a guide, there are a number of signposts we are watching to determine the path ahead.
We anticipate that high commodity prices, tight labour markets, high housing costs, and shortages of goods and materials across industrial sectors will keep inflation elevated in the months ahead. Yet, it appears that inflation may have already peaked at very high levels. July’s Consumer Price Index print is being interpreted as favourable by markets, though we think it’s notable that the breadth of inflation is actually still rising. The Fed’s moves, which are part of the fastest global central bank pivot ever, appear to be having the intended effect, though we think it is too soon for the Fed to declare victory.
Inflation will likely drop as the Fed’s aggressive efforts to dampen demand take hold and supply constraints slowly ease. However, the peaking process will likely be longer and more arduous than anticipated, as the underlying drivers of inflation have transitioned from acute price pressures in a few areas, such as used cars or airfares, to a broader-based basket of domestic and international goods and services.
It is our view that slowing demand and tightening policy will result in significantly lower inflation rates by the end of 2023. A key question is whether inflation will fall by enough to satisfy the Fed. On that front, the key question is what the Fed will be willing to accept.
We do believe inflation will remain higher than it was during the pre-pandemic, post-Global-Financial-Crisis recovery, stemming from a confluence of supply and demand-side considerations.
On supply: the Russian invasion of Ukraine, China’s relatively punitive policy toward zero-Covid containment, and secular transition from fossil fuels to renewable energy sources all have potential to curtail the immediate and available supply of goods and services globally.
On demand: the introduction of means-based income-replacement programs during the Covid-19 pandemic represented a potential turning point in fiscal policy activism that may have popular support in the years ahead.
Again, what is important to note is that the efforts to rein in inflation have pushed the U.S. economy into a slowing period. Our base case is that slowing growth and still-high inflation mean we will be in a stagflationary environment for some time, and that has significant implications for portfolio construction.
Importantly, real assets typically outperform stocks and bonds during periods of lower-than-expected growth and higher-than-expected inflation, demonstrated both historically and in performance in the first half of this year. As forces behind inflation persist—high commodity prices, tight labour markets, high housing costs—the odds of remaining in a favourable regime rise.
Key questions remain for portfolio managers: How much of a hard landing scenario is priced into markets? And how should this factor into positioning, given the macro environment as well as valuations—many of which have been driven down significantly?
Here are our key outlooks:
Real asset classes offer the potential for compelling diversification benefits at a time when inflation hedging is taking on added importance. Stocks and bonds have historically delivered their strongest returns in periods of low inflation and may be in a precarious position if elevated inflation rates persist. Real asset classes, on the other hand, have historically outperformed in inflationary periods, to varying degrees.
For our part, we remain overweight in natural resource equities, as all of its sectors are well situated for the current global environment, in our view. We are overweight global listed infrastructure due to the asset class’s attractive fundamentals and relative valuation. We have a tactical underweight in commodities due to the risk of prices pulling back from current levels. We remain underweight real estate stocks based on concerns about rising interest rates, and we are underweight in the dedicated gold allocation due to a less attractive relative valuation and expectations of ongoing U.S. dollar strength.
We maintain a balanced portfolio, with a slightly more defensive posture given elevated inflation, central bank tightening and the potential for slower growth. We are actively seeking opportunities from higher-quality companies that have better growth potential in a weaker economic environment. Among the portfolio’s more defensive allocations, we remain overweight communications infrastructure and waste management, and we are underweight utilities.
U.S. Real Estate
Real estate offers the potential to mitigate inflation’s impact. While growth is slowing and the odds of a recession have increased, the job market remains healthy. Consumers are generally in good shape, although their savings cushion is diminishing as they pay more for goods and services. Fundamentals generally remain sound, but slower growth and higher inflation cloud the outlook for real estate, particularly for sectors lacking pricing power.
We have reduced our expectations for earnings and net asset values accordingly, though we still anticipate healthy earnings growth this year and next. Moreover, traditional asset categories may have less ability to defend against a prolonged environment of higher inflation than real estate companies, which generally have high operating margins, low commodity and labour price sensitivity, and (in many cases) inflation-linked rents.
The market has repriced significantly this year, and we think preferred valuations look attractive relative to other fixed income investments; given all-in yields well above recent historical averages, we believe term investors will be rewarded. The general quality of the preferred market could help it outperform high yield securities, in our view. In addition to general balance sheet strength, banks and insurance companies, the largest issuers of preferreds, typically benefit from rising earnings as short rates rise.
We believe their higher income levels and generally more modest duration risk could help preferreds outperform investment grade corporate bonds over time. Finally, preferreds can provide attractive after-tax returns due to the qualified dividend income (taxed at a maximum U.S. Federal tax rate of 20%) that many pay, potentially making them attractive relative to municipal bonds.