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By Anwiti Bahuguna, Ph.D., Senior Portfolio Manager, Head of Multi-Asset Strategy

The Fed takes a potentially aggressive path in an effort to tame inflation. Investors fear a recession may be on the horizon.

The Fed gets real about inflation

For the last two years, inflation has been a bogeyman for the markets — higher and stickier than expected. To combat higher than expected inflation, the Fed has been telegraphing an aggressive position on hiking the Fed funds rate. Markets are now expecting nine hikes, bringing the central bank’s overnight rate to 2.00%–2.25% by the end of 2022.

Recession fears on the rise

Recession fears became headline news when the yield on the 2-year Treasuries briefly rose above the yield on the 10-year Treasuries. Historically, some yield curve inversions have presaged a recession.

But a single yield curve inversion on its own is an imperfect recession predictor: an inversion may precede a recession, but not all inversions culminate in a recession. Taking a broader look at the economy, we believe that although the fundamentals remain strong — particularly the labor market — there’s an expanding list of risks to growth, including the ending of fiscal and monetary stimulus, sanctions on Russia and the war in Ukraine.

With this increased concern about recession, it’s important to recognize that not all recessions are the same. They have different drivers, which can impact their duration and severity.

In the current environment, calibrating monetary policy precisely enough to slow growth but not to cause a downturn is a significant challenge for central banks given the relatively blunt tools at their disposal. Investors may be concerned that policymakers are playing catch-up and may end up tightening interest rates well above what the economy can handle.

Risk assets can still do well, even when the yield curve is correct

We’ve looked at how stocks tend to perform in the period between yield curve inversions and the start of a recession (when it has occurred). And while there are only a limited number of periods to consider, we found that frequently equities rise, and sometimes quite strongly.

Bottom line: Charting the course from here

Given the macroeconomic headwinds, we expect growth to slow to “near trend” levels this year from the very high growth rate in 2021. In fact, first quarter GDP numbers released in late April showed an unexpected decline of 1.4%, but this was mostly due to technical factors and not necessarily recessionary. Underlying trend growth, as measured by private domestic demand, was solid and still above trend. But in the coming quarters, rising rates and declining real incomes could take a bite out of consumer spending and result in further slowdown. Our base case is that we avoid recession, but the risks are rising.

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