Persistent inflation ‘makes recession likely’, says Betashares’ David Bassanese

Betashares chief economist David Bassanese doesn’t think inflation will fall fast enough to avoid a recession and deeper bear markets in shares.

David Bassanese says it’s all about inflation in 2023.

Markets have endured a rough ride in 2022, with aggressive rate hikes by central banks to fight inflation stemming from supply disruption and economic reopening.

Shares entered bear markets and government bonds suffered some of their biggest sell-offs in decades. Commodities and currencies saw volatility exacerbated by a strong US dollar and China’s property crisis and extended Covid-19 lockdowns.

The Betashares chief economist doesn’t think inflation will fall fast enough to avoid a recession and deeper bear markets in shares. In that regard, a slowdown in the pace of rate hikes by the US Federal Open Market Committee after its meeting this week won’t matter as much as its “terminal rate”, Bassanese says.

Federal Reserve chair Jerome Powell and other officials have repeatedly forecast that the required peak policy rate is expected to be higher than what was contemplated in September projections. Markets have priced in an increase in the terminal rate implied by the Fed’s “dot plot” of rate expectations of its members, rising to a range of 4.75-5 per cent from 4.5-4.75 per cent.

Some forecasters, including Citi, have predicted the Fed's median "dot" for the end of 2023 will be revised up to 5-5.25 per cent.

“Ultimately it’s all about inflation, and whether the Fed has to create a recession to get inflation down,” Bassanese says. “Unfortunately, it probably is going to take a hard landing.”

Goods inflation in the US is coming off as supply chains normalise. US inventories have surged relative to sales. But a big chunk of inflation is in services, which tends to be “sticky”.

Services inflation is underpinned by wage growth that’s still running at 5 or 6 per cent.

It comes after US core PPI ex-food and energy rose 0.4 per cent in November, exceeding a 0.2 per cent rise expected by markets. Together with stronger-than-expected US consumer confidence data, the PPI increase pushed the S&P 500 down to a four-week low.

The market will get an important update on US inflation when November CPI data are released on Tuesday. The CPI data will be last bit of information feeding into the FOMC decision. The FOMC will announce its decision at 6am Australian time on Thursday, along with the Fed’s latest economic projections and interest rate forecasts.

Mr Bassanese doubts US wage growth can come down on its own accord. In that case, the US unemployment rate will need to rise from multi-decade lows.

“Historically when the US unemployment rate goes up by half a per cent it has triggered a recession, and it has never stopped there – it has ended up going higher by 2-3 per cent.”

In that case, the current bear market in US shares could be extended.

While the S&P 500 rebounded 17 per cent from mid-October through November, Bassanese thinks it will fall as low as 3100 points in 2023, breaking the current 2022 low near 3500.

His target represents a 21 per cent fall from the current level and a peak-to-trough fall of 35 per cent, in line with the average fall of the S&P 500 in a recession.

The US economy typically enters a recession when the US Treasury bond yield curve becomes “inverted” as it has been of late. The two-10 year spread hit a four-decade low near -80bps.

The US sharemarket has never bottomed before the start of a recession. “The more I look at their inflation and wages numbers, and what the Fed themselves are saying, it’s hard to see everything miraculously going right in terms of inflation, without a hard landing,” Bassanese says.

In his view, the consensus estimate for US corporate earnings per share growth of 4 per cent for 2023 will be cut to minus 5-10 per cent over the next six months.

The S&P 500’s current 12-month forward price-to-earnings ratio of about 18 times is “still pretty elevated” versus a long-term average of 16.5 times.

For the bond market, Bassanese says the key is how high the Fed funds rate needs to go to lower inflation close enough to the Fed’s 2 per cent target and avoid a damaging “prices-wages spiral”.

A Fed funds rate of 4.75-5 versus the current range 3.75-4 per cent should be enough.

But if the economy remains resilient, the Fed will do more.

“If anything, there may be a risk that they end up doing more than what the market expects,” he says. St Louis Fed President James Bullard has flagged a potential rise to 5-7 per cent.

But on a positive note, the Fed is not expected to cut rates by 50bps in the second half.

He also sees the Reserve Bank raising its cash rate by another 50bps to a terminal rate of 3.6 per cent, before cutting rates by 50bps in the second half of 2023.

“The big difference between the two countries is that our growth here is still at relatively benign levels, whereas in the US it is well above levels consistent with their inflation target,” Bassanese says. “The second difference is our economy is more sensitive to short-term interest rates because our mortgages are more variable rate rather than fixed rate. The third point is that what happens in the US will impact on us.”

For Australian shares, he thinks a US recession will outweigh any positive impact of China reopening.