Fed Hikes & Beyond: Is a recession looking imminent?

PMI and housing data are deep in contraction territory which suggests that 2023 earnings estimates are far too optimistic and need to come down further.

Fed Hikes & Beyond: Is a recession looking imminent?
The U.S. economy has already stalled and now we see a recession in the cards for early next year.

US recession 2022 has become the talk of the town and the whole world is talking about it now. The US, after all, has a big say in the world of trade and businesses owing to the large size of its $23 trillion economy. The United States is home to the world’s biggest financial market but the economy is staring at a recession.

The market capitalization of US companies in the Global Top 100 has grown at a CAGR of 18% and 15% in the last five and ten years respectively and up 19% in the year to March 2022. However, the future ahead looks bleak for the economy thus impacting the growth of companies.

The growth witnessed in the past is under threat as the US has already witnessed two consecutive quarters of falling GDP growth. The price rise in the US is at several decades high and not looking to come down in a hurry.

While there could be supply-side issues leading to inflation, the US Fed has a job at hand. An interest rate hike looks to be the primary weapon for the Fed to bring inflation down from around 8% to under 2% in the economy. Fed has already hiked the rate by 225 bps in 2022 and either 75 bps or even a larger 100 bps rate hike is expected on September 20-21 when FOMC meets to decide on a rate hike.

Rate hikes will have consequences on the larger population and the economy as well. Fed Chief Powell had made it quite apparent in Jackson Hole that the Fed does not currently have any plans to halt its cycle of rate increases. He warned of more pain for individuals and businesses because of rate hikes.

Tony DeSpirito, BlackRock Fundamental Active Equity Investment Team in a recent note writes, “The Fed’s ability to raise interest rates and reduce its balance sheet in a way that neither inflames inflation nor stifles economic growth will have a significant bearing on the market backdrop. We are not calling for a recession, but we are cognizant that the risks of a recession are rising. If the Fed tightens too much, the result could be a recession. If it tightens too little, inflation is a greater threat. The ideal scenario runs in the middle, allowing for a soft landing as policy transitions.”

Also Read: Will US Fed go for 50 bps or 75 bps points hike in the FOMC meeting in September?

A higher interest rate makes borrowing expensive for businesses and individuals. With lesser incentive to borrow and invest in the economy, the impact on credit growth gets visible over time. Corporate profits see a fall and so do the margins of companies thus impacting the stock prices.

Ray Dalio, Founder, Co-Chief Investment Officer, and Member of the Bridgewater Board recently warned of a steep 20% fall in equity prices if US rates get around 4.5%.

Also Read: Equities may see a 20% decline if rates rise to around 4.5%: Ray Dalio

The damage to the economy is for real. “PMI and housing data are deep in contraction territory which suggests that 2023 earnings estimates are far too optimistic and need to come down further. The U.S. equity and bond market remain overvalued,” says José Torres, Senior Economist at Interactive Brokers

The only way the Fed can quickly reduce inflation is by hiking rates so high that demand is reduced to what the economy can comfortably produce right now. But, by keeping increasing rates, the damage to the economy cannot be ruled out. BlackRock, in its weekly commentary states, “The U.S. economy has already stalled. Now we see a recession in the cards for early next year. We estimate 3 million more people would be unemployed if demand were to contract by 2%.”

Once the contraction in the economy is more visible, the recessionary environment may not be far behind. Will the Fed stop hiking rates after the damage is done and the US economy is well entrenched in a recession is what economists and investors are more concerned for. The likelihood of a recession happening in the U.S. in the next 12 months is now at about one in three. If the U.S. economy slips into a downturn in the next year, there’s at least one consolation: the contraction isn’t expected to be deep, according to Goldman Sachs Research.

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