Authors
Evan Brown Ryan Primmer

So far this year, the US Federal Reserve has raised rates over six straight meetings by a total of 375 bps. Assuming the Fed follows through with an expected 50 basis points hike in December, it will have delivered the most cumulative tightening in any calendar year since 1980. The speed and magnitude of rate hikes is, by design, weighing on the US economy in order to bring inflation down.

Amid this backdrop, over 75% of fund managers think a recession is likely over the next 12 months – a level roughly on par with peak pessimism during the global financial crisis in 2009 and the COVID-19 pandemic in 20201.

While a recession is a very real possibility, investors may be surprised by the resilience of the global economy – even with such a sharp tightening in financial conditions. The labor market will certainly cool, but healthy household balance sheets should continue to support spending in the services sector (Tables 1&2). Moreover, some of the major drags on the world economy emanating from Europe and China are poised to get better, not worse, between now and the end of Q1 2023.

Avoiding a recession would clearly be good news; however, it would not signal an all-clear for risk assets. A more resilient economy may also mean central banks need to do more, not less, in order to get inflation durably back to target. And this raises the risks of a harder landing down the road. But, in our view, it is too early to pre-position for very negative economic outcomes. A longer-lasting late cycle environment can persist for some time, and investors will have to be flexible and discerning in 2023 given these potential dynamics.

Table 1: US Labor Market Metrics to Monitor

US Labor Market Metrics to Monitor

US Labor Market Metrics to Monitor

Most recent data*

Most recent data*

End-2019

End-2019

Difference

Difference

US Labor Market Metrics to Monitor

Unemployment rate (U3)

Most recent data*

3.7% (Oct)

End-2019

3.60%

Difference

+0.10%

US Labor Market Metrics to Monitor

Private Employment Cost Index: Wages and Salaries

Most recent data*

5.3% (Q3)

End-2019

3%

Difference

+2.30%

US Labor Market Metrics to Monitor

Initial jobless claims

Most recent data*

222K (Nov 12)

End-2019

235K

Difference

-13k

US Labor Market Metrics to Monitor

Continuing jobless claims

Most recent data*

1.5m (Nov 5)

End-2019

1.9m

Difference

-400k

US Labor Market Metrics to Monitor

Prime-age employment to population ratio

Most recent data*

79.8% (Oct)

End-2019

80.30%

Difference

-0.5%

US Labor Market Metrics to Monitor

Aggregate labor income (YoY)

Most recent data*

8.7% (Oct)

End-2019

3.70%

Difference

+5%

US Labor Market Metrics to Monitor

Private sector quits rate

Most recent data*

2.9% (Sept)

End-2019

2.60%

Difference

+0.3%

Source : Bureau of Labor Statistics, Department of Labor. *Now data: Unemployment rate as of October 2022, Private ECI as of September 30, 2022, Initial jobless claims as of Nov. 12, 2022, Continuing jobless claims as of November 5, 2022, Prime age employment to population ratio as of October 2022, Aggregate labor income as of October 2022, Private sector quits rate as of September 2022.

Table 2: Developed market central banks’ key wage metrics

Central Bank

Central Bank

Key Wage Metric

Key Wage Metric

%YoY Chg (Latest Reading)

%YoY Chg (Latest Reading)

Central Bank

Federal Reserve

Key Wage Metric

Private Employment Cost Index: Wages & Salaries (Q3)

%YoY Chg (Latest Reading)

+5.3%

Central Bank

European Central Bank

Key Wage Metric

ECB Indicator of Negotiated Wages (Q2)

%YoY Chg (Latest Reading)

+2.4%

Central Bank

Bank of Japan

Key Wage Metric

Scheduled Contractual Earnings (Sept)

%YoY Chg (Latest Reading)

+1.6%

Central Bank

Bank of England

Key Wage Metric

Average Weekly Earnings Ex-Bonus/Arrears (Sept)

%YoY Chg (Latest Reading)

+6.3%

Central Bank

Reserve Bank of Australia

Key Wage Metric

Wage Price Index Ex-Bonus (Q3)

%YoY Chg (Latest Reading)

+3.1%

Central Bank

Reserve Bank of New Zealand

Key Wage Metric

Index of Salary & Wages (Q3)

%YoY Chg (Latest Reading)

+3.9%

Central Bank

Bank of Canada

Key Wage Metric

BoC Common Wage Index (Q2)

%YoY Chg (Latest Reading)

+3.3%

Sources: US Bureau of Labor Statistics, European Central Bank, Japan Ministry of Health, Labour, and Welfare, UK Office for National Statistics, Australian Bureau of Statistics, Statistics New Zealand, Bank of Canada.

The Fed vs. the US labor market

To best understand US economic dynamics, it is necessary to break down the US labor market into lower and higher income cohorts. Lower wage employees, who are disproportionately employed in the service sector, are experiencing very strong wage growth (Chart 1). This is happening in large part because higher income workers still have a lot of excess savings, which they are ready and more than willing to spend in the service sector2 . While high earners have a lower marginal propensity to consume (that is, they spend a smaller percentage of their income compared to lower earners), they also account for the lion’s share of total consumption (Chart 2).

Chart 1 - US income growth is strongest among the lowest earners

A line chart showing wage trends among US workers, split out between four quartiles. The first wage quartile represents the lowest earners and indicates that the lowest earners are experiencing the strongest wage growth.

This chart shows that while all workers are experiencing strong earnings growth, it is particularly pronounced among the lowest earners, represented by the first wage quartile.

Chart 2 – Top 40% of earners account for 60% of spending

A pie chart showing the share of US consumption by income quintile

This chart shows the share of US consumption by income quintile as at January 1st 2021, indicating that the top 40% of earners account for 60% of spending.

It is the Fed’s job to cool this situation down, and make sure it doesn’t turn into a wage-price spiral. The Fed’s tightening of financial conditions has meant some progress in slowing aggregate labor income, cooling the housing market and bringing down goods consumption. But the service spending dynamics mentioned above are unique to this COVID-19-driven cycle and arguably tougher to break. We believe this means the US economy (and earnings) probably don’t fall off as sharply as many are projecting, and, however, also the Fed will need to keep rates higher for longer.

In the meantime, China is signaling the relaxation of zero-COVID-19 measures, even in the face of elevated case counts. In our view, this suggests a commitment to such a shift in policy, which should allow for a boost in consumption. The process is unlikely to play out in a straight line, but the direction of travel seems pretty clear, to us. Our confidence that the bottom is in for China is fortified since these adjustments to COVID-19 policy are taking place in tandem with the most comprehensive support for the property sector to date. A rebounding China may provide a needed boost as developed economies slow, but will also likely lead to higher commodity prices. This too may make it difficult for the Fed and other central banks to back off too quickly.

Asset allocation

Macro and cross-asset volatility are unlikely to fade away along with the calendar year. And the distribution of outcomes remains much wider than investors became accustomed to in the previous cycle. Our focus is therefore on positioning over the coming months as opposed to the coming year, and we are ready to pivot as the business cycle evolves.

Going into 2023, we expect global equities at an index level to remain range-bound. They will likely be capped to the upside by the Fed’s desire to keep financial conditions from easing too much. However, we expect some cushion on the downside from a resilient economy and rebounding China.

The relative value opportunity set across global equities appears fertile. Financials and energy are our preferred sectors. This is because we believe cyclically-oriented positions should perform if what appears to be overstated pessimism on global growth fades in the face of resilient economic data. Activity surprising to the upside and a higher-for-longer rate outlook should benefit value stocks relative to growth, in our view – particularly as profit estimates for inexpensive companies are holding up well relative to their pricier peers.

On a regional basis, Japan is buoyed by a rare combination of accommodative monetary and fiscal stimulus.

We are neutral on government bonds. The Fed is likely to be slow in ending or reversing its hiking cycle as long as the US labor market bends but does not break, while signs that overall inflation has peaked may reduce the odds of over-tightening. However, price pressures are likely to remain stubbornly high – a side effect of a US labor market that refuses to crack. China’s reopening should fuel a pick-up in domestic oil demand, offsetting some of the downward pressure on inflation from goods prices. In US and European credit, investment grade bond yields look increasingly attractive as a balance between a potentially resilient economy and more range-bound government bond yields.

We see commodities as attractive both on an outright basis and for the hedging role they serve in multi-asset portfolios. Already low inventories can continue to shrink in an environment of slowing growth so long as supply remains constrained – as is the case across most key commodity markets. Securing sufficient access to energy is not a problem that will be solved at the end of this winter – and may grow more intense as Chinese demand increases if mobility restrictions are removed. In addition, commodities have a track record of strong performance during months when stocks and bonds suffer meaningful declines.

In currencies, we believe we have moved from a strong, trending US dollar to more of a rangebound trade in USD. Our catalysts for a broad turn in the dollar are for the Fed to stop hiking interest rates, China’s zero-COVID-19 policy to end, and energy pressures in Europe stemming from Russia’s invasion of Ukraine to subside. None of these have fully happened yet, but all three appear to be getting closer. A more rangebound dollar coupled with a global economy that is still growing, but slowing, could provide a very positive backdrop for high carry, commodity-linked currencies. We prefer the Brazilian real and Mexican peso.

Chart 3: S&P 500 margins tend to be positively correlated with jobs, spending growth

A line graph showing the correlation of S&P 500 profit margins against jobs and consumption growth

This chart shows that the profit margins of S&P 500 companies tend to be positively correlated with job and spending patterns

About the authors
  • Evan Brown

    Head of Multi-Asset Strategy

    Evan Brown, CFA is Head of Multi-Asset Strategy in the Investment Solutions team at UBS Asset Management. In this role, Evan drives macro research and tactical asset allocation investment process for over USD100 billion in client portfolios. Additionally, he is responsible for advising UBS Asset Management’s global institutional and private wealth client base on the macroeconomic outlook and asset allocation.

    View full profile
  • Ryan Primmer

    Head of Investment Solutions

    Ryan oversees UBS Investment Solutions, including Asset Allocation, Portfolio Management, Implementation, Analytics, and Modelling teams. Ryan rejoined UBS in June 2018 from KCG Holdings, holding roles like Head of Quantitative and Systematic Trading, and Head of Global Quantitative Strategies. At UBS (1991-2013), he held leadership roles including Global Head of Equities Trading, Global Head of Equities Proprietary Trading, and Head of SNB StabFund Investment Management managing distressed mortgage assets.

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