The consensus view shift toward a mild downturn looks misplaced
Early in 2023, the consensus view was that a global recession was coming later in 2023. But as the year has matured, the consensus outlook has completely shifted. A soft landing – or even no landing – is now the consensus. What is remarkable is how strong the consensus has become. The consensus is, indeed, so consensus!
I think differently. A soft landing is merely a convenient and comfortable fairy tale, back fitted to match the market prevailing narrative and based on backward-looking unique circumstances. A hard landing is coming – it’s just a matter of when.
Likely one-offs provide false hope
Europe’s warm winter allowed the region to avoid a deep recession, which was viewed as almost inevitable amid the high energy prices and supply problems following Russia’s invasion of Ukraine. This led to a burst of optimism about the region coming out of the winter.
The European energy dynamic has surely improved, but probably not enough. Will we get another warm winter? I’m not sure investors should be allocating capital based on that hope.
On the fiscal side, US growth received a boost from the Inflation Reduction Act in early 2023. It authorised almost $900 billion of total spending, mostly dedicated to manufacturing and climate change projects1. While the fiscal impulse may still be positive, its power is waning.
Also, during the US regional bank crisis in March, the Federal Reserve (Fed) stepped in to create a new term funding facility to ease the liquidity crunch at banks. Markets anticipated that the Fed would soon slow or stop its rate hikes, leading to a material loosening of financial conditions2.
The two-year US Treasury note yield plunged to 3.77% on March 24 from 5.07% on March 8 as markets rapidly repriced their expectations for Fed tightening3. Mortgage rates fell, providing another fleeting boost to the economy as yields and mortgage rates have now moved back up in response to the soft landing narrative.
Aggressive tightening, leverage set stage for hard landing
It already appears that global manufacturing is flashing signals of being in a recession. The Covid-induced boom in the services sector is showing signs that it is also past the peak. Labour markets are not as strong as they were.
Most importantly, when global economic activity indicators were around current levels in past economic cycles, central banks were already well into rate-cutting mode. But this time around, we have central banks still tightening while also winding down their balance sheets through quantitative tightening.
Making matters worse, all the conditions for a hard landing are present. Leverage in pockets of the financial system seems to be rising, and we know from past experience that elevated leverage can quickly cause cracks to become craters. And we’ve already seen some cracks – regional bank liquidity problems in the US as well as severe stresses in China’s property sector and UK pension funds. I fear that the next one may be a crater.
