US economy not broken, but recession looms: UBS

The Fed hasn’t broken anything yet but deep cracks are forming, according to UBS global head of economics Arend Kapteyn.

The Fed hasn’t broken anything yet but deep cracks are forming, according to UBS.

In this environment, investors shouldn’t extrapolate the post-CPI rebound in US shares.

The recent strong rebound will fade as recession looms, and the Fed lifts interest rates until it has done enough to ensure that inflation will return to its target, says the Swiss investment bank’s global head of economics and strategy research, Arend Kapteyn.

The good news is that the Fed will quickly pivot to rate cuts in the second half of 2023 to reverse some of its “excess tightening” when the unemployment rate starts to rise.

By that point, there should be a string of inflation results annualising at acceptable levels.

Interest rate cuts by the Fed could have significant implications for the Australian dollar, potentially allowing the Reserve Bank to cut rates in the second half of the year, as UBS expects.

But Kapteyn sees a fall in US sharemarket valuations next year as earnings downgrades loom amid recession risks from the impact of monetary policy tightening and a lessening of reopening demand, lowering the S&P 500 to 3200 points by mid-2023.

That’s about 20 per cent below the 4000 level reached after lower-than expected US CPI data sparked a 5.5 per cent jump in the S&P 500 on Thursday night, its biggest daily rise since April 2020.

A forecast of 375 basis points of rate cuts by the Fed in the second half of the year leads UBS to expect the S&P 500 to rebound to 3900 points by the end of 2024.

Kapteyn’s forecast of rate cuts assumes that the US enters a recession, core personal consumption inflation falls to 2.1 per cent annualised, and the unemployment rate rises to 5.5 per cent.

Speaking to The Australian on the sidelines of the UBS Australasia Conference in Sydney on Monday, Kapteyn said the US was “already barely growing” and the cumulative impact of rate hikes would continue to be felt.

“Payrolls are actually the only thing that’s resilient, everything else has already stalled,” he said.

“Consumption has barely grown for 10 months, retail sales have hit a wall, inventories are rising at a time of excess capacity, and you’re seeing a savings drawdown signalling consumer distress. People are having to draw down their savings just to stand still, you no longer have any Covid-19 reopening tailwinds, and now on top of that you have higher borrowing costs, so it looks like the US is heading to even weaker growth numbers, and in that environment pricing power is weakening.”

While many have highlighted positive seasonal factors and a historically positive impact from midterm elections, UBS forecasts imply that investors face a negative return from the US market for the next 12 months, primarily due to its forecast of a recession.

A further rebound to 4400 by late 2024 is expected, assuming the Fed slashes its policy rate to 1.25 per cent by the March quarter of 2024 and holds it there through the year.

The Swiss investment bank sees a stronger rebound in the fixed income market. The US 10-year bond yield is expected to fall from a high of 4.15 per cent in the December quarter to 2.1 per cent by the March quarter of 2024. Bond prices move inversely to yields.

Notwithstanding recent stress in UK financial markets and cryptocurrencies, the Fed’s aggressive 375 basis point lift in interest rates plus quantitative tightening since March haven’t “broken” anything significant enough to cause the Fed to stop rate hikes.

But US job losses are expected to rapidly worsen the post-Covid reopening slowdown in US consumption and an already rapid downturn in the housing market.

Interestingly, when FOMC member Christopher Waller was asked at the conference if he was concerned about rate hikes “breaking” anything, he framed his reply around the strength of employment, reaffirming the Fed’s focus on the labour market.

“I think they’re actually breaking the housing market,” Kapteyn said. “If you look at the responsiveness of residential building activity, it’s faster than anything we’ve seen in prior hiking cycles, and prices are now falling rapidly.”

UBS forecasts have the US recording a consequential 4.5 percentage point contraction in GDP for three quarters starting in April and ending in December.

Global economic growth is expected to be “historically weak”.

Kapteyn’s forecast of 2.1 per cent growth would be the eighth-weakest year for the global economy since the late 1960s and the weakest since 1993 outside the Covid-19 pandemic and the global financial crisis, making it a “recession of sorts”.