While projections for the probability of a recession are still very low (less than 10%), there are multiple indicators suggesting that it may rise considerably in the next 12 months, primarily emanating from the stagflationary impact of hyperinflation.
The unwinding of high inflation can happen broadly in three ways:
- Sudden and considerable easing of supply bottlenecks (rise in labour supply, wages coming off, technological transformation, commodities crashing, etc.); something that had backed the US Federal Reserve’s failed transient inflation hypothesis,
- Orderly response to the Fed’s normalisation, including a moderate rate lift-off and gradual balance sheet taper. This is seemingly unlikely given the extent to which the Fed has lagged.
- High inflation getting entrenched, transforming into a difficult hyper-inflation and stagnation (or stagflation) and eventually a recession as the central bank is forced to take stronger and surprise tightening measures to tame inflation.
While the nature of future adjustments may involve a mix of all the above three elements, the probability of Scenario c) is surely rising.
Typically, a recession should have already set in with 40-year high inflation. But what is holding it back is the fact that the Fed has kept the real rate at an 80 year-low of -6%. Also, the lingering impact of fiscal stimulus has sustained the strong consumption growth at 7.5% even as real personal income growth (excluding transfers) has decelerated to a 2-year CAGR of 1.2% after rebounding 9.5% from the Covid bottom.
Moreover, the Philadelphia Fed manufacturing sector survey suggests that the concurrent situation on current order book and current delivery time remain elevated, thereby creating a sense of robustness. But, simultaneously, indicators on future new orders and supply time have plummeted. The current pattern of high core inflation (6%), robust concurrent indicators on new order book, and tight supply chain along with weakening consumer sentiment and future order book is similar to the scenario seen in 1972.
1972-75 saw US real GDP growth swinging from 7.2% to -2% and a stock market crash (-45%) even as consensus expectation was of a robust cyclical momentum However, most probability measures of an impending US recession are low; 1.8% as per Chauvet et al, and 6% based on 10 year-3 month treasury curve spread(NY Fed, Jan’22).
The US 10 year-3 month spread is currently reasonably wide at 160 bps, much higher than 0 to -50% spread that typically occurs before a recession. Thus, the probability of a recession can rise considerably if the Fed rate is hiked to 2.0-2.5% from the current zero levels, thereby flattening the curve. But raising the rate to 2.5% is also imperative for the real rate to reach a commonly assumed neutral level of 0.5% from the current -6.0%.
The US Fed has an unenviable choice to make; take swift and steep tightening action while the concurrent growth is still strong, thereby tame inflation and improve future prospects or let stagflation turn into a recession. The best way to address this conundrum will be to initiate large rate hikes of 125-150bp in the next 12 odd months beginning with an immediate 50 bp hike when the concurrent economic data is still strong, while also adopting balance sheet taper of USD 15-30 billion can prevent undue flattening of the treasury curve. These can be followed up with the regular hikes of 25bp after 12 months.
By easing the inflationary pressure such a strategy can improve the prospect for future economic indicators such as consumer confidence, order book and real income growth, thereby diminishing the probability of a recession. The matter has got confounded by the fallout of the latest Russian incursion into Ukraine, as it can compound the inflation problem if crude prices shoot up beyond the $100 mark.
The markets will be burdened with greater uncertainty from the geopolitical risks from the invasions on top of the fallout from a potentially steeper US monetary tightening in response to hyperinflationary trends. The rise in the real Fed rate from a 70-year low of -6% (net of core inflation) will pull down both US profitability and valuations. Marked deceleration in earnings growth, stagflation, rising risk-free rates, and higher market risk premium will impact both earnings projections and valuations for equities and risk assets, including EM and India equities.
Hence, the consensus earnings projection for Nifty companies of 18-19% growth for FY23-24 looks considerably optimistic. During the better growth phase of FY08-FY19, real GDP growth averaged 7% and was matched by Nifty EPS growth of 6.7%.
(The author, Dhananjay Sinha, is Managing Director & Chief – Strategist, JM Financial Institutional Securities Ltd. The views are his own)
