Central banks have delayed fighting inflation longer than in previous cycles, which could signal a hard recession is coming.
Markets could face a hard landing this year as central banks loosen monetary tightening and plunge the economy into recession, according to Nicholas Ware, manager of monthly fixed-income fund Janus Henderson.
Early intervention in the inflationary cycle could have a significant impact on a possible recession, but this time the central banks had to react later than any other recession.
One of the leading indicators is the labor force. If there is high unemployment and inflation, central banks will have a lower ceiling for rate hikes as wage inflation is less likely to rise and demand is likely to dry up faster.
With low unemployment and high inflation—as we have today—central banks will raise rates, leading to wage inflation, meaning that the hike is less likely to have an immediate impact on inflation, which could lead to further and more aggressive hikes.
This is illustrated in the chart below, where green dots represent soft landings and red dots represent hard landings. He argued that the Fed’s starting point last year, shown in yellow, was much less favorable than previous recessions.
Rate of inflation and unemployment at the start of previous interest rate cycles
Source: Janus Henderson.
Ware said: “We had high inflation and low unemployment. This means that the Fed has done a very difficult job of slowing down the economy. Where you start matters, and it will happen throughout the year.”
A hard landing involves central banks acting too hard and too fast and pushing the economy into recession, while a soft landing would require a rebalancing that would lower inflation and minimize damage to markets.
Central banks are trying to raise interest rates enough to stop the economy from overheating and also prevent a recession, but according to Tom Stevenson, Fidelity’s chief investment officer, this is “much easier said than done.”
“In practice, the degree of monetary tightening required to contain inflation usually results in a hard landing in the form of a recession and rising unemployment,” he said.
Indeed, most major central banks have raised interest rates to their highest levels in decades within months, and Ware doesn’t think they have stopped yet.
He said: “The Fed will likely raise a couple of times more – it shouldn’t, but it probably will.”
However, when it finally unwinds, the drop in rates is likely to be as sharp and fast as it has been in past cycles.
Number of months from last Fed raise to first cut
Source: Janus Henderson.
Ware said, “In the 70s and 80s, which is the most current story, they were quickly cut off, and I think we’re going to see something similar this year.”
Many central banks in emerging markets have been more proactive in fighting inflation, allowing them to wind down monetary policy while developed countries are still on the rise.
BlackRock recently announced that this is the reason why it will be allocating more funds to emerging market stocks in the short term, with the firm taking a tactical underweight position in developed markets as a worrisome recession approaches.
According to Ware, leading indicators pointing to a recession have not yet bottomed out, “signaling a deep recession to come.”
In anticipation, he increased the holding of investment-grade bonds in the Henderson Diversified Income Trust as he expects these assets to be the most resilient in a hard landing scenario.
From now on, Ware intends to invest in high-yield corporate bonds “when the economy starts to fall.” Investment grade bonds currently account for 48.8% of the trust’s assets, while high yield corporate bonds account for 41.3%.
He said: “In the past, we have moved between investment grade and high returns, and both have served us very well.”
However, where an investor places funds at this stage depends on how they see the global economy moving, with different areas of fixed income moving in opposite directions in different potential outcomes, as shown below.
Scenario Analysis of Fixed Income Returns
Source: Janus Henderson.
Ware said: “If you think we are heading into a recession, you should be placing funds at the top of the fixed income market.
“If you think we are heading for a soft landing, you can just buy the whole market because everything will be fine. The problem is that soft landings and hard landings look the same.”
The debate about how the economy will play out is likely to continue, but Joanna Kirklund, chief investment officer at Schroders, said there are indicators that investors can look to as they try to set the overall direction.
“I think there are potential upside risks in 2023 at this point, especially if the Fed can arrange a soft landing,” she said.
“The main thing to look at is the direction of inflation: the more inflation falls, the more room they have to maneuver and the more room for markets to move higher.”