Is North America Headed for a Recession?

The North American economy continues to send conflicting signals. While the U.S. Federal Reserve and the Bank of Canada struggle to curb record-high inflation with a string of rate hikes, their moves have done little to cool equity markets and employment gains. When will rising interest rates start impacting the economy and will higher borrowing costs and continued rising inflation tip North America into a recession?

To address these questions BMO Financial Group’s U.S. Chief Executive Officer David Casper convened a panel titled “Will We or Won’t We? Inflation, Rising Interest Rates and the Threat of Recession” to explore how this unprecedented economic moment may unfold. He was joined by Scott Anderson, Chief Economist at Bank of the West, which after the recent acquisition by BMO is the newest member of the BMO economics team, Brian Belski, BMO Capital Markets’ Chief Investment Strategist, and Earl Davis, the Head of Fixed Income and Money Markets for BMO Global Asset Management.

While the panel was reluctant to say if or when the U.S. or Canada might enter a recession, they said investors need to prepare for a bumpy ride. “The U.S. and Canadian economies are in an unfamiliar twilight of an economic and financial boom,” said Scott Anderson. “Forecasting through this pandemic has been one of the most challenging of my career, maybe for economists all over the country, including at the Federal Reserve.”

Anderson said there’s a high risk of a U.S. economic recession in 2023, possibly in the next three to six months – although it’s not a sure thing. “I put the probability at around 60%,” he said. He expects a two-quarter downturn possibly starting in the second quarter of 2023, with a 0.8% decline in U.S. GDP from peak to trough, a loss of a million jobs and the U.S. unemployment rate moving up to 4.8%.

Overall, Anderson said he expects inflation to be lower at the end of 2023 than when the year began and believes it will take until the end of 2024 before the Fed reaches its 2% inflation target.

While Anderson said there is a high risk for recession, Earl Davis noted that fixed income markets are sending a different signal. “We read the (bond) market as pushing out the probability of recession and reducing the probability of one in 2023,” he said.

Regardless of the level of risk of a recession, the panel agreed it won’t be a smooth ride. According to Davis, the only certainty about fixed income in 2023 is increased uncertainty and volatility. “Keep in mind that it’s not just about the destination now – rates higher, rates lower – it’s about the path to get there,” he explained. “Similar to 2022, we’ll see interest rates spike higher and then spike lower.”

Economic data in March and April will play a major role in how high the Fed ultimately raises its target range for the fed funds rate. “If you get two strong prints, that’s a tentative trend,” said Davis. “And if you get three, that’s a trend.” In February, it rose by 25 points to 4.75%, from 4.5%, a smaller increase, but an increase nonetheless, based on January data that showed strong employment, strong retail sales and a rebounding consumer price index.

At the moment, the bond market is signalling that the Fed will top out at 5.5% in late summer, but Davis said the March economic data will determine if that sticks. “There’s not a lot of slack in the economy,” noted Davis. Against that backdrop, he said the Fed may need to raise interest rates to as high as 6%, although he thinks if the Fed and the Bank of Canada do raise rates again, it will be by 25 basis points.

As for the equity markets outlook, Brian Belski remains optimistic that the slide has stopped. “We still think the U.S. stock market is in the midst of a big 25-year secular bull market that started in 2009,” he said.

Belski noted that historically, the stock market has only experienced three consecutive negative years – all during moments of economic crisis: 1938-40 (Depression), 1972-74 (oil embargo), and 2000-02 (tech bust and 9/11). “I don’t think we have a crisis like that right now,” he said, but investors need to play it smart.

He believes that too many people are trying to figure out what the Fed’s next move will be and where the economy is headed. “That’s really difficult to do, and when it’s difficult, you default to quality,” said Belski. “It’s time for fundamentals to lead.” In this environment, Belski said he would look to value stocks, small and mid-cap stocks, quality stocks and growth at a reasonable price.

This is a return to normal, he argued. Until recently, interest rates have been well below long-term averages since the 2008 financial crisis, so Belski said he expects there will be a rebalancing in the next three to five years. “We’re going to normalize valuations, we’re going to normalize earnings growth to single-digit earnings growth and high double-digit performance in the stock market.”

With that will come a shift back to investing fundamentals like stock selection and diversified portfolios, like the 1980s and the early 1990s. “In ’94-’95, you could own both stocks and bonds and from a total return perspective, they worked very well together,” he said.

All of the panellists shared the view that financial markets are entering a new era. “We’re undergoing a secular change in inflation,” said Davis, in which modestly higher inflation of three and 4% will be acceptable. He pointed to the five-year mandates central banks in Canada and the U.S. signed in 2021 to keep inflation between 2% and 3%. “When those expire in 2026, the inflation mandate is going to be set higher. The central bankers realize it’s going to be a 10- to 20-year period of higher inflation, higher volatility, generally higher interest rates,” he said.

Anderson also sees a larger shift underway. When inflation first broke out, most economists blamed supply chains and the war in Ukraine. But now, he sees the impact of the Fed more than doubling the size of the balance sheet and the U.S. federal government spending trillions of dollars on major spending packages. “Inflation might be around for a while,” said Anderson.

“This will be unlike any recession period we’ve seen in most of our working careers,” noted Anderson, who explained that you have to look back to the 1970 and ’80s to find a comparable scenario. “I’m old enough to remember the inflation we had in the ’70s and early ’80s wasn’t an easy animal to dispense with. The Fed has got to be prepared that this might be a bigger battle.”

Despite the economic challenges, Belski said he remains bullish on equities. “I still believe that the U.S. stock market is the best equity asset in the world,” he said, adding that investors should be able to find opportunities in every sector. “You don't have to own everything, just be very selective.”

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