The Economy’s Walking A Tightrope: Here’s How To Prepare For Both A Crash And A Soft Landing

A lot can change in a couple of months, and that’s especially true in an uncertain environment like this. So I’ve compared abrdn Research Institute’s latest quarterly economic outlook to its outlook at the beginning of the year, and made note of what’s changed – and the potential implications those adjustments could have for your investments.

What were abrdn’s key calls at the beginning of the year?

Revelers might have been cheery back when the bells rang in a new year, but abrdn was far from optimistic. Here’s what the Research Institute predicted a few months ago:

• Pandemic-induced distortions and commodity price rises would calm and put less pressure on inflation – but inflation from the labor market would be a tougher nut to crack.

• Interest rates will rise in the US to cause a recession before they’re cut in the second half of 2023.

• Other central banks would be forced to increase rates until a recession hits, then would also cut rates by the end of 2023.

• China’s economic growth would miss targets.

• A global recession.

What are the key differences in the recent quarterly report?

Overall, abrdn’s key forecasts from the start of the year remain mostly unchanged. The standout difference is its outlook on China, though. Back when abrdn made its cautious China call, both the prospect of lingering lockdowns and an indebted property sector were holding back economic growth. But then the country “reopened” sooner than expected, with newly relaxed restrictions leading to a stronger-than-expected rebound – and there’s plenty of room for China to keep that going. abrdn now not only expects China’s economic growth to exceed refreshed predictions of 5% versus last year, but also sees a moderate spillover into emerging markets.

What is the base case scenario?

Resilient economic growth in the US, Europe, and China might’ve pushed out abrdn’s initial expectation of a recession until later on in 2023, but the firm remains increasingly confident that a recession is still coming – and is actually needed to cool down the overheating economy. Now, abrdn believes a US recession will start in the third quarter, with the country’s economy falling by about 2% over the next three quarters. And while abrdn only expects a mild recession, the shock to the system would still lead to a spillover to financial markets – one that abrdn doesn’t believe has been priced into stock markets. On a wider scale, abrdn forecasts that the eurozone, UK, and Japan will also fall into recessions this year and next.

What are the other scenarios?

The main alternative plausible scenario is that the Federal Reserve (the Fed) “walks the tightrope” and succeeds in bringing about a “soft” landing – that’s a controlled slowdown of economic growth that skims but avoids a harsher recession scenario.

abrdn can also conceive of a “sticky inflation” scenario, where higher interest rates cause a recession but underlying inflation proves much more persistent for a longer time. The rate-cutting cycles in this baseline scenario would likely be shallower, so interest rates would stay higher for longer.

A new scenario introduced by abrdn this quarter is the “Fed has two bites of the cherry” scenario. This scenario sees higher interest rates having limited initial impact on growth and inflation – a “no landing” scenario. The Fed would then be forced to hike rates to nearly 7%, which would push the economy into a delayed but deeper recession.

abrdn economic scenarios. Source: abrdn

You can see these different outcomes in the chart above. The baseline scenario contains a US recession, and looking at all the predictions, a hard landing (letter X) is more likely than a soft landing. Plus, probability-weighted outcomes are skewed toward higher global growth and inflation than in the baseline.

What does this mean for your portfolio?

It’s worth noting that abrdn’s latest outlook was published in March – before the latest banking crisis. This crisis will likely undermine economic growth and increase the probability of a recession. See, the crisis could well push banks to tighten their lending standards in a bid to strengthen their balance sheets, meaning there’s less money available for businesses that need funding to grow, in turn slowing companies’ growth.

In the base case scenario, China seems to be a promising investment, but mainly in the consumption and services sectors rather than the commodities side. In that case, you could consider buying the iShares MSCI China ETF (MCHI; 0.58%) or the KraneShares CSI China Internet Fund ETF (KWEB; 0.69%).

With a US recession likely in a base case, a defensive tilt to your investments may be warranted. So taking an underweight position in stocks or investing in gold and bonds – government or investment-grade corporate ones – may help produce more stable returns. Where stocks are concerned, an increased focus on quality companies in defensive sectors like consumer staples, utilities, or healthcare may be sensible.

Meanwhile, the more optimistic “the Fed walks the tightrope” scenario – where the Fed manages to bring about a soft landing – would foster a better environment for stocks. In this case, you could consider adding more to stocks with the SPDR S&P 500 ETF (SPY; 0.095%)

The “sticky inflation” and “two bites of the cherry” scenarios would welcome higher-for-longer interest rates. That’s not good news for stocks, especially growth or technology ones, so they’d likely decline in value. But despite rampant inflation and hot-to-touch global growth data, the recent banking crisis has seen the market rapidly reverse its expectations for higher interest rates. The markets aren’t currently pricing in any further rate hikes in the US this year but are expecting at least two interest rate cuts, while the Fed’s official message remains that there will be no cuts this year. That seems to make the “sticky inflation” and “two bites of the cherry” scenarios look that bit less likely.