In the second half of 2022, we saw a slow economy, rising inflation, and concerns about a recession. This period drew parallels to the Icarus myth, with business activity appearing to descend rapidly as excessive inflation began to singe the wings of the economy. However, the analogy stumbled a little; unlike Icarus, the economy merely skimmed the surface of recession as global GDP growth fell to a low 1-2% level by the end of 2022. A downturn was avoided, and a strong recovery started in 2023.
Europe managed to deal with the energy crisis, avoiding a deeper recession. China reopened and recovered from the COVID-related slowdown, followed by the US. The global economy, despite early signs of fragility, showed strength with the pace of global growth reaching about 4% levels during Q1. The growth outlook for the second quarter is still robust, albeit at a slower pace than the previous period, due softer growth momentum in China.
Late Cycle Caution
However, we are currently in the later stages of the business cycle, and with rapid wage growth of around 4-6% in the US and Europe and low unemployment rates, there are increasing fears of a recession. We believe an economic downturn might occur late 2023 or early 2024. Predicting the exact timing of a recession, however, remains an ever-challenging task.
The current economic phase is usually characterized by a strong economy on one side and a potential recession on the other. Consumer spending and employment growth have fuelled the 2023 economic recovery. However, manufacturing has suffered as consumer behaviour has pivoted from goods towards services, reflecting a post-pandemic reopening trend. Although global manufacturing began to show signs of recovery early this year, it has yet to ascend to significant growth levels.
The Sun Always Sets in the West
Without a US recession, a global downturn is not likely. The US economy is expected to have a brief, shallow recession later this year, a so-called soft landing. Other possibilities include a more prolonged slowdown combined with sticky inflation. Some economists predict an even milder scenario where the US economy decelerates but deftly sidesteps an actual recession, much like the pre-pandemic cycle following the global financial crisis.
It is still possible that we are heading for U-shaped recession lasting 3-4 quarters. This version could inflict more harm on both the economy and financial markets. A tight credit environment, propelled by restrictive central bank policies, could be the catalyst for this classic recession trajectory and seems the most likely prospect for the upcoming year. But even within this framework, there's a chance the recession could prove to be relatively mild.
What’s Attractive, What’s Not?
Investments in corporate bonds look attractive, offering 4-8% yield levels. However, the stock market, particularly US stocks, looks overpriced with higher risk than corporate bonds. For example, in 2023, European equities are up by 11% while high yield bonds have returned 5%, but with less than a third of the risk of equities. Furthermore, earnings growth may continue to be negative in late 2023, which poses a higher risk for equities. Therefore, over the medium-term, we prefer credit over equities.
On the other hand, we would argue that lofty equity valuations matter less in the short-term. Therefore, equities could still offer some upside potential, provided market momentum remains strong.
Market Outlook
Optimism about avoiding a recession led to a boost in equity markets in October, and both European and US stocks have since increased by over 20%. There was a setback due to a minor bank crisis in the US, but the overall market trend has remained positive.
In this landscape, we advise a neutral stance towards equities, with the odds evenly split between a soft-landing and a potential recession.
Recently, the equity market has become narrow, with the spotlight focused predominantly on the US technology sector, which has been pumped up by the AI boom in 2023. Yet, there's a chance the upbeat move in stocks may persist through the summer, spurred by cautious investor sentiment, positive economic activity, and continually upgraded, albeit modest, Q2 corporate earnings expectations.
However, the stock market might show weaker performance later this year due to weakening economic fundamentals and earnings. Currently, the timing of such a market turnaround is challenging, but would likely occur at a time when economic momentum turns negative.
If signs of an upcoming recession would start to build up, it's recommended that investors adopt a defensive strategy with less risky assets such as equities in the portfolio, keeping the powder dry. Why? Because the best long-term investment opportunities often emerge during a recession. This happens when the economic outlook is gloomy, but the foundations for a recovery are being laid.
The tide is turning slowly in the Nordic countries
As the global economy is holding up and inflation pressures start to abate, the Nordic economies are bottoming out. The real estate and housing markets in Sweden are picking up after the brutal start to the year. The turnaround is probably not decisive yet as inflation is still stubbornly high. The Riksbank will have to stay hawkish probably longer than the ECB. The economic uncertainty has contributed to the continued weakness of the Krona. That it turn benefits Swedish export companies. All that is still needed is a boost from global demand.
Finnish export companies bear the brunt of the weak Krona relative to euro. Nevertheless, economic activity, business and consumer confidences in Finland have improved from their low points. Finland has attracted lately new energy investments that will materialize during coming years. A new right wing government is about to start its term and its programme will include economic and tax reforms.
Peter Lindahl
