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IS A SOFT LANDING POSSIBLE?

Mark Holman

Partner, Portfolio Management

Meet Mark

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TwentyFour Blog
| Read | 3 min
1 Apr 2022

As this remarkable cycle rapidly progresses, thoughts have more recently turned
to the chances of a US recession in 2023, and whether the Fed can somehow pull
off a soft landing.
 
The rapid flattening of major government bond yield curves, and in particular
this week’s brief inversion of the closely-watched 2s-10s differential in US
Treasuries, have pushed this issue to the forefront of investors’ minds.
 
We are all now highly familiar with what a 2s-10s inversion typically means,
which is a US recession will surely follow. However, it is worth pouring a
little cold water on its predictive power as the timing of the subsequent
recession varies so much. Historically it has taken as little as nine months and
as long as nearly four years to appear, so while the reliability of the outcome
can’t be denied, the timing makes it impossible to use as anything more than a
warning signal. When the yield curve inverted in August 2019 and a recession
followed in March 2020, no one had even heard of COVID-19. The inversion was
correct as usual, but the recession that followed occurred for reasons that
could not have been predicted.
 
Back to the recent flattening and this week’s curve inversion, I think we have
to put this down to forward guidance, which is something investors have only
benefited from in relatively recent history. The whole yield curve has moved
rapidly higher, but the front end has outpaced the overall move because
investors have reacted to the Fed’s forward guidance and priced in so many rate
hikes, which in our view makes this rather less useful as a recession indicator.
In fact, it’s questionable in economic terms how useful forward guidance can be
when it comes to monetary policy tightening. Clearly it’s useful when the
central bank wants to lend monetary support to a flagging economy, but the same
cannot be said about the current situation. Nevertheless, here we are and the
debate is open about a soft landing.
 
In our opinion, a soft landing in the US is still more likely than a hard
landing, but it is clear that inflation is more persistent and at higher levels
than the Fed has previously guided, which means a series of rate hikes is
inevitable – and at a hiking pace that markets have not recently been accustomed
to. It’s also clear that the US consumer has already endured a tough 12 months
of inflation, which will have impacted spending power. These conditions look set
to continue throughout 2022, and it comes at a time of sharply rising rates.
Consequently it feels inevitable again that consumer confidence will be eroded,
though government actions such as the recent oil reserve release can help at the
margin. For a consumer driven economy like the US this is not good news, and
therefore we have to factor in a reasonable dent to previously forecasted GDP
growth. 
 
However, our base case remains that a US recession will be avoided in 2023; we
would put the chance of recession next year at something like 35%. This positive
rationale is based on the evident strength of the economy as we entered 2022,
and therefore the large buffer that the economy had to deal with the many shocks
it has encountered. Absent that buffer our view would be different, as after all
the economy has had to endure a supply chain shock, a demand shock, a
consequential inflation shock, a commodity price shock and of course war in
Ukraine. If we then add a material amount of monetary policy tightening, we must
conclude that the large buffer the economy had in 2021 will be eroded by the end
of 2022.
 
If the rate hikes come through as expected we will have a US economy that has
all the hallmarks of being late-cycle and without a large GDP growth buffer to
rely on. This is the typical late-cycle position that investors face.
 
Before getting too bearish though, a late-cycle economy can last a long time and
risk assets can become quite expensive in late-cycle, though of course that is
not always the case. However, it is worth remembering it is usually some sort of
shock or surprise to the economy that tips the cycle over the edge and once we
reach late-cycle the economy is at its most vulnerable, so any fresh surprises
might not be absorbed the way the recent ones have been.
 
So our base case is that the economy lands softly, but by the time it does, we
will either be close to or in late cycle, and we can hope valuations pick up and
follow along the way. Additionally, long dated US Treasury yields are climbing,
which should help investors balance portfolios when we get there.

 



 


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