Strong employment is a common thread binding the improving growth outlook for major economies, as low unemployment and healthy nominal wage growth have sustained household spending. However, this labour market strength could become a double-edged sword.
If robust consumer spending is maintained, demand for goods and services could remain strong, causing their prices to appreciate at a pace above central banks’ long-term inflation targets. This is known as demand-pull inflation. In a similar vein, companies may continue to raise prices to mitigate high labour costs, a concept known as cost-push inflation. As such, monetary policymakers may keep policy rates in restrictive territory longer than anticipated.
Higher-for-longer monetary policy rates are problematic for excessively indebted households, businesses, and governments; the longer policy rates remain elevated, the more vulnerable economic participants become. Debt-related vulnerabilities exposed by higher interest rates underpin our base case for a mild recession. However, the range of possible outcomes remains wide, from a soft landing (inflation eases without a recession) to a deep and prolonged economic downturn.
Figure 1: Stay the course to navigate uncertainty
Uncertainty about the path forward for the global economy warrants staying invested and having a high-quality bias. If our base case for a mild recession comes to pass, well-diversified portfolios of high-quality assets should perform relatively well. Additionally, market volatility could lead to temporary price dislocations of high-quality companies, allowing opportunistic investors to add exposure at attractive valuations. Conversely, if the economy manages to avoid a recession, staying invested should allow investors to participate in the upside.
Over the long haul, well-established trends should result in inflation and interest rates declining to levels that support long-term economic growth. Although the timing of this is uncertain, the global economy cannot sustain a prolonged period of high-interest rates due to the excessive debt loads encumbering broad swaths of the economy.
Investors should be wary
Equity markets have been strong in 2023, with the S&P 500, European Stoxx 600, German DAX, and the Japanese Nikkei indices all enjoying solid runs. Despite the uptick, we question the durability of the rally as we believe risks remain elevated for equities.
A 20% rally during a bear market is not unusual. The dot-com bust saw three rallies greater than 20% before the S&P 500 ultimately met its low. Similarly, two rallies greater than 20% in 2008 were eventually followed by the index bottoming in March 2009. Our work shows that, on average, six rallies occurred in the past six U.S. bear markets, each lasting 27 days on average and resulting in a recovery of ~8%.3
With earnings estimates remaining mildly negative and several leading economic indicators pointing to a possible recession, investors should approach the equity market strength with caution.
Rising leverage is a concern for some corporate borrowers
High-interest rates and elevated labour costs are headwinds for corporate borrowers, particularly those in the high-yield space. Such companies, which tend to have limited pricing power and constrained credit metrics, face another obstacle: rising leverage (the ratio of net debt to some measure of cash flow or capital).
According to Bloomberg, net debt relative to earnings for U.S. high-yield issuers has increased since the third quarter of 2021. New issue volume for high-yield is also up so far this year. As a result, more high-yield issuers are borrowing at higher interest rates and face rising debt-servicing costs. In an environment of elevated interest rates and inflation, leverage may prove difficult to contain, let alone reduce, leading some rating agencies to flag it as a top worry among credit investors.
In our view, higher leverage could lead to increased high-yield default rates. Investment-grade borrowers are less susceptible to default than high-yield issuers and should be better positioned to weather an economic slowdown.
1 Scotia Wealth Management, Bloomberg, Federal Reserve Bank of New York, S&P | From NY Fed’s research paper titled Monetary Tightening Cycles and the Predictability of Economic Activity.
2 Scotia Wealth Management, Bloomberg, Federal Reserve Bank of New York, S&P | Includes government, household, financial, and non-financial corporate debt.
3 Scotia Wealth Management, Bloomberg | A bear market is defined as an equity market decline of 20% or more. In this context, a bear market rally is defined as a market advance of 5% or more that occurs within six weeks (30 trading days) of a rolling 8-week (40 trading days) low during a bear market.
