The pandemic altered many “typical” business cycle dynamics over the past three years, so this cycle has been anything but normal, but consensus entering 2023 held that a recession was imminent.
By late January, after cooler inflation and wage prints, a soft landing became the primary storyline. Several Federal Open Market Committee (FOMC) members reinforced this possibility. With firming inflation data and an economy appearing to re-accelerate despite one of the fastest starts to a U.S. Federal Reserve rate hiking cycle in modern history, today’s narrative centers on whether the Fed is behind the curve…again.
Even with improving momentum, we continue to believe a recession is in the cards this year.
This belief is based on the nature of the economic data that has been surpassing expectations. Most of the reports that have surprised to the upside have been lagging or coincident in nature. This demonstrates more about where the economy has been than where it might be headed.
For example, non-farm payrolls are a coincident indicator, useful in real time, which can be non-linear, collapsing rapidly as a recession takes hold. Healthy payroll readings in one month mean little in forecasting where they may be in the next quarter or two, but they are improving.
Other improvements in U.S. economic data over the last month have been robust and broad-based, including job openings and retail sales. The Citigroup Economic Surprise Index started February at -6.1 and ended at +38.6, reflecting a series of better-than-expected economic data releases.
On the back of this renewed economic momentum, many investors adopted the view that a soft landing – or no landing – will materialize. Google searches for “soft landing” jumped to a 15-year high last month. Search activity was last at (or greater than) current levels in May 2008, a few months prior to Lehman Brothers’ bankruptcy and the onset of the Global Financial Crisis.
Many leading indicators look far more precarious. January marked the tenth consecutive monthly decline in the Conference Board’s Leading Economic Index (LEI). This is more than double the string of declines seen ahead of past recessions (four months). Trouble signaled by other major leading economic indicators affirms our view that a recession looms on the horizon later in 2023.
As a result, 2023 should continue to be a choppy year for equities. A tactical opportunity is emerging in high-quality dividend growers. The year-to-date rally has been led by 2022’s laggards, growth stocks, as investors buy (and/or cover shorts) in the most beaten-down areas of the market.
Better economic data points have created a bid for more cyclical areas, so defensives and quality have been relative laggards.
If our recession call for 2023 is correct, a reversal of recent leadership should ensue. This should support blue chip dividend growth stocks, which have historically outperformed during and after the onset of monetary tightening cycles.
Equities demonstrating these characteristics also could do well in a “no landing” scenario in which the Fed would hike rates even further than anticipated. This could be caused by overly resilient economic growth and elevated inflation, similar to much of 2022.
The action to start the year should serve as an important reminder that many head fakes and pockets of optimism occur along the way as the economy moves toward and through a recessionary period.
Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns.
Data sources: GoogleTrends, Citigroup, The Conference Board.