A New Scenario to Gauge the Outlook

The economic outlook is quite difficult to get a clear read on right now. In February we presented three scenarios. Those were Recession, Extended Cycle, Productivity Boom. We have returned to these, but we have also added a “Stagflationary” scenario. Although tech stocks have enjoyed the rally recently, we think the Productivity Boom is least likely as they would require a significant acceleration in earnings growth to justify current valuations – that has been evident this earnings period where even companies which beat earnings expectations were punished on poor guidance.

The narrative has shifted.

GDP growth slowed materially in QI, surprising markets. The US economy grew 1.6% over the quarter, well below expectations and a marked jump lower compared to the previous quarter. Although this is a backward-looking indicator, it has driven a significant shift away from the narrative that the US economy has continued to be robust despite higher rates. The manufacturing PMI – a more timely indicator – also slipped back into contractionary territory in March compared to a surprisingly strong February.

Chart 1: GDP growth has slowed – but not collapsed.

Source: Bloomberg LP, Oreana.

At the same time, inflation has proved sticky, and even reaccelerated in recent months. On a rolling 3-month basis, the Fed’s preferred core PCE inflation measure is back above 4%. That measure had fallen below 2% towards the end of last year, driving the Fed’s hawkish pivot late last year. This pop up in inflation will make it difficult for the Fed to cut in the near-term. We have already seen a repricing from nearly 7 rate cuts this year in priced in January, to around 1 now priced for this year.

Chart 2: Inflation has proved sticky – and has reaccelerated.

Source: Bloomberg LP, Oreana.

The Australian economy has seen a similar trend. Quarterly inflation was strong in QI leaving annual inflation well above the RBA target. The sticky annual inflation challenges the RBA view that we will revert to target by 2025. That has led to a huge repricing in rate cut pricing in Australia. Rate hikes are now priced as markets are concerned that inflation will continue to reaccelerate. The consensus has shifted rapidly – challenging the RBA’s credibility.

Chart 3: Australian inflation has also reaccelerated.

Source: Bloomberg LP, Oreana.

Scenarios help assess the outlook.

We now have 4 potential scenarios – Recession, Extended Cycle, Productivity Boom, and Stagflationary. We think the Productivity Boom scenario the least likely, as there is a high hurdle for current valuations. We think Recession and Extended Cycle are more likely, but we are keeping an eye on the Stagflationary indicators.

Table 1: Scenario analysis for 2024

The outlook has become less clear

In summary, we think scenarios are helpful in guiding portfolio decisions. Markets are currently extremely reactive to economic and earnings data. The risk of disappointment remains high, particularly if growth slows back to or below trend. As the economy data are somewhat mixed, we continue to monitor our key economic signposts including the manufacturing PMI, the change in the unemployment rate and the yield curve for guidance on which of these three scenarios is most likely.

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