03 Aug 2022 3 min read

Markets rally amid recession fears

By Emiel van den Heiligenberg , Tim Drayson

Maybe, just maybe, we have gone past peak pessimism and peak volatility for now. However, we believe darker clouds are gathering over the longer-term fundamental outlook.


We believe the recent rally was driven by earnings relief (nominal variables remained strong), no disaster around Russian gas deliveries, some progress on Chinese real estate woes and most importantly a kind of ‘goldilocks’ US Federal Reserve (Fed) scenario. The central bank’s recent messaging was taken to suggest fewer hikes ahead, leaving some questioning the idea that the US economy is already in recession. Risk markets loved it, real yields fell and so did volatility. Investors who are positioned very bearishly scrambled to cover some of their short positions.

Storm clouds gather

Our thoughts on the 12-month outlook are becoming gloomier, though the negative GDP in first half of the year complicates the picture, but the US has been rapidly losing momentum primarily due to the inflation shock. Yet falling gasoline prices in recent weeks are about to boost real incomes.

Tim Drayson, our Head of Economics, flagged the US senior loan officer survey released this week showed a swing to a modest tightening in lending standards, which is a classic very late cycle indicator. Like credit spreads, it is worse than a normal expansion phase, but is not yet signalling actual recession. The overall pace of tightening was 0.5 standard deviations, a level that is rarely stable.

In 2007 it hovered around these levels before spiking in 2008. We also briefly saw this level in 1998 before a final late-cycle growth spurt in 1999, but we believe there is very little prospect of the Fed coming to the rescue in the near term since it wants to tighten financial conditions to contain excess inflation.

The US recession indicators in our heatmap (see below) suggest the probability of recession has risen further. But supply-side indicators appear to be improving, and forward-looking inflation news appears better. On the one hand, some of the softening in inflation could be due to weaker demand (and possibly a recession soon) but alternatively, by slowing earlier, the risk of further overheating and recession at a later date might have diminished.


In conclusion, we keep the probability of a US recession in the second half of 2022 at 20% (though it should have fallen by now since it is August). We raise the probability of a recession in the first half of 2023 to 40% (was 35%) and the second half of 2023 to 60% (was 55%).

With these darkening fundamentals in mind, and given the S&P 500 index is now close to the level we previously identified as profit-taking levels, we have started to fade the tactical long position we hold. We fear that the summer optimism might prove to be nothing more than a midsummer night’s dream.

Recession base case in Europe

Though Russian gas supply has resumed, retaining Russia’s valuable export and state revenues from the pipeline, the gas crisis continues. European natural gas prices reached their highest level since immediately after the invasion of Ukraine, based on the announcement that Russia would cut supply to 20% of capacity pending another round of maintenance.

At these levels of delivery, European rationing of gas usage becomes inevitable as the inventories accumulated over the summer will most likely be insufficient during the winter.

What could this mean? There is some anecdotal evidence of industry cutting production. Our Senior European Economist, Hetal Mehta, has increased our European recession probabilities even further (65% for the second half of 2022 to 85% by the end of 2023). There are three reasons for this:

  1. Euro area credit conditions have tightened significantly
  2. The continued squeeze on real incomes from energy prices
  3. Consumer and producer sentiment has collapsed and are pointing to contraction

We have positioned for this recession risk with several trades in various strategies: long bunds versus gilts and treasuries, long defensives versus cyclicals, and long US equities versus Euro equities.

Emiel van den Heiligenberg

Head of Asset Allocation

Emiel is responsible for the overall strategic direction of the team’s investment and business strategy. He claims to have been a promising lightweight rower at university until French fries got the better of him. Reflecting his love for rowing in a team, he firmly believes that excellence can only be achieved by a great team made up of motivated individuals that are also eager to work together. To this end he is the self-proclaimed inventor of the verb 'teaming' to acknowledge that shaping a top team and culture of excellence is an ongoing process. Outside of work-family obligations, Emiel’s spare time is filled by a passion for shark diving and skiing. Prior to dedicating his career to portfolio management in 1996, Emiel worked as a policy adviser in the Dutch Ministry of Finance and he graduated from Tilburg University in the Netherlands ages ago. When not glued to his Bloomberg screens, this Dutch man is hooked on computer games, peanut butter and his favourite dark beer made by Belgian monks.

Emiel van den Heiligenberg

Tim Drayson

Head of Economics

Tim keeps a close watch on global economic developments, with a particular focus on the US. He believes nothing good ever happens after midnight, which is why he is rarely spotted out late. Tim joined in 2008 from the number-one ranked economics team at ABN AMRO, with prior experience from HM Treasury, and graduated with a MSc from the University of Nottingham. When not crunching economic data, he can be found studying the weather forecast, analysing his cycling statistics or looking anxious on three-foot putts.

Tim Drayson