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Market Outlook: Recession Risks Rise Thumbnail

Market Outlook: Recession Risks Rise

Market Outlook: Recession Risks Rise

The financial markets experienced a turbulent first quarter of 2023, with various factors contributing to market volatility. Slower liquidity growth, inflation concerns, and uncertainty surrounding monetary policies all played a role in shaping market dynamics. However, some of these challenges have already been priced into the markets, particularly in fixed income and non-US equities.

Economic indicators suggest a cooling of inflation rates, but the potential for a recession continues to build due to a deteriorating earnings outlook, expectations of slower sales growth, and negative earnings growth. While inflation pressures stemming from transitory factors such as supply chain disruptions have eased, demand-side factors could contribute to sustained inflation in the services sector if tight labor markets persist.

The yield curve, specifically the 10-year minus 3-month Treasury yield, experienced its most significant inversion since 1981. This inversion has historically preceded economic weakness, occurring prior to the last eight recessions. The timing between curve inversions and recessions has varied historically, ranging from four to 21 months.

Late-cycle trends were observed during the first quarter, with the earnings outlook weakening and expectations of slower sales growth and negative earnings growth for 2023. US banks also tightened lending standards across multiple loan categories, reflecting caution in the face of potential risks. The failure of two regional banks in the first quarter heightened concerns and could lead to further credit tightening, particularly among smaller regional banks with exposure to commercial real estate loans.

Globally, manufacturing activity decelerated in developed markets (DM), while emerging markets (EM) experienced mildly expansionary industrial activity. The global cycle has become less synchronized, with China's economy accelerating and Europe stabilizing amid falling energy prices. Central banks worldwide implemented tightening policies to address rising inflation, with EMs nearing the end of their hiking cycles while DMs faced persistent pressures.

In terms of asset markets, US growth stocks were powered by rallies in the technology and communications services sectors during the first quarter. Fixed-income categories posted positive returns as yields dropped. However, financial stocks and commodities lagged due to concerns over banking stress and commodity demand. Valuations rose for both US and non-US developed markets as stocks rallied, though trailing one-year price-to-earnings (PE) ratios for non-US stocks remained below their long-term averages.

Global earnings growth slowed in the first quarter, returning to more sustainable levels after a spike during the 2021 profit recovery associated with economic reopening. EM earnings, which had contracted in the past two quarters, showed signs of stabilization as China's economy reopened. Expectations for global earnings growth over the next 12 months remain relatively muted.

From a currency perspective, weaker US growth compared to the rest of the world suggests a more favorable medium-term outlook for non-US currencies. Additionally, non-US currencies appear undervalued in the long term relative to the US dollar. While extreme financial turbulence or a severe global recession historically boosted the dollar, non-US currencies are expected to provide potential upside and portfolio diversification benefits.

US Treasurys experienced a drop in yields, accompanied by widened credit spreads across most fixed-income categories during the first quarter. The turmoil in the banking sector played a role in these movements. Yields and spreads for major bond categories finished around or above their averages over the past two decades. After years of low bond yields and tight credit spreads, fixed income assets now offer relatively better income opportunities and more attractive valuations.

In conclusion, the market outlook suggests increased risks of a recession due to various factors such as deteriorating earnings outlook, inflation concerns, and monetary policy uncertainties. While some of these risks have been priced into the markets, caution and diversification remain crucial. The financial markets continue to navigate a volatile environment, presenting both challenges and opportunities for investors.

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This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.