An Investor’s Guide To The Impending Recession (... Or Not)

The Federal Reserve has just upped interest rates by 0.75% in the biggest increase since 1994 – a slam-on-the-brakes that doesn’t bode particularly well for the global economy. But where exactly we go from here isn’t set in stone: there’s a lot of talk about a recession, sure, but it’s not a foregone conclusion. In fact, according to investment manager abrdn, there are four possible scenarios here. So let’s take a look at each of them, and how to invest whichever one you find yourself in.

Scenario 1: Fed kills the cycle (35% probability)

By far the most likely scenario, according to abrdn, is that the US economy gets thrown into a recession as the Fed raises interest rates in response to high inflation, and that the downturn spreads. Not that the rest of the world needs much to tip it into a recession.

Already, China’s zero-Covid policies have likely driven the country’s economy to shrink this quarter versus the last, and the eurozone and UK economies are likely to contract later this year, with sky-high energy prices largely to blame. Stateside, there’s already been one quarter of negative economic growth, and we’re seeing a slowing in business investment and the all-important consumer spending.

Why abrdn thinks this is most likely: Historically, when inflation is this high and unemployment this low, it’s almost impossible for the Fed to hike rates without causing a recession. As businesses and consumers respond to higher rates with slower spending, abrdn sees the US sliding into a recession by late next year. A shrinking US economy will hit its developed market trading partners like Europe hard, prompting haven-seeking investors to ditch emerging-market assets, putting pressure on those currencies and economies – and tipping the world into recession.

How to invest: According to abrdn, US rates will continue rising between now and mid-2023. And US banks with large domestic savings and lending businesses tend to benefit the most from higher interest rates because they can increase their “net interest margin” – the gap between the interest they charge borrowers and pay savers – which, all else equal, flows through to higher profits.

Scenario 2: Fed nails the “soft landing” (20% probability)

This scenario is perhaps the one everyone, from central bankers to individual investors, is rooting for: the Fed and other major central banks continue to hike rates to combat inflation, causing a slowdown in economic growth – but not a recession.

What to look out for: To spot whether this scenario is playing out, keep an eye on whether the Fed’s key interest rate rises above 2.5% by the end of this year – if it does, that’s a hopeful sign – and whether investors’ expectations of inflation begin to fall back toward long-term average levels (around 2%). An improvement in “labor force participation” and slowing wage growth may also signal the Fed’s managing to keep all its plates spinning. If it can do that, abrdn estimates that global economic growth will be 2.5 percentage points higher than its current forecast in two years’ time and inflation 2 percentage points higher too.

How to invest: In addition to banks benefiting from rising rates, “early cyclicals” may stand to benefit from an unexpected uptick in demand if there’s a soft landing. That could mean a boost for consumer discretionary stocks, financials, and real estate, as well as autos and household durables (think: white goods).

Scenario 3: There’s a supply side recovery (15%)

This scenario sees supply chain disruptions fading quickly and labor supply picking up sharply (helping improve the labor force participation rate). That could be thanks to a shift in demand from goods and toward services, which would ease the price pressures on physical goods, hopefully without creating similar pressures on services. That’d mean inflation would fall more quickly than expected, and central banks would need fewer rate hikes than they’re currently expected to make.

What to look out for: We’d need to see a quick recovery in labor market participation, a sharp decrease in supply chain disruptions and production delays, and a stabilization in service industry prices even as demand continues to rise. abrdn estimates that’d add 4.5 percentage points to global economic growth two years out and only 1 percentage point to inflation versus its current forecasts.

How to invest: With lower inflation, we’d see lower central bank interest rates, and that could be a recipe for investors to become more “risk on”, picking up assets they previously ditched in fear of a prolonged hiking cycle. So growth stocks, particularly loss-making tech stocks, might swing back into investors’ favor – and so too might cryptocurrencies, which have proved themselves a risk asset in recent months.

Scenario 4: There’s a stagflationary shock (10%).

Here, geopolitical tensions would fuel a further surge in commodity prices and disruptions across goods production and transportation, meaning supply chain issues last even longer than feared, and inflation stays higher for longer. It would force consumers to rein in their spending even more, and heap more pressure on central banks to hike interest rates faster and more aggressively, as the global economy stagnates and multiple regions tip into recession. The eurozone would be at particular risk, in this scenario, given its reliance on Russian energy.

What to look out for: Spikes in energy, food, and metals prices could suggest we’re on the way to stagnation. Other clues: seeing real-world prices for goods and services – as well as worker wages – increase before your eyes. Business surveys might also offer other evidence: a drop-off in activity and confidence, for example, and, of course, continued higher-than-expected inflation that isn’t immediately responded to by higher interest rates from central banks. In this scenario, abrdn forecasts global economic growth would come in 1 percentage point higher than its forecasts in two years’ time but inflation 5 percentage points above.

How to invest: Defense may be the best offense for investors. Stocks in defensive sectors like consumer staples and healthcare, and telecoms sell things people need to buy no matter the state of the economy or how expensive borrowing is – and should therefore be better able to pass on higher costs to customers while maintaining steady profit margins.