Fathom Consulting’s Global Outlook, Winter 2022[1] focuses on recession risks, forecasting that the UK and euro area are probably already in a downturn, with the US likely to join them early next year.
Some might query this gloomy view when, on the face of it, the economic news in the last quarter has been comparatively upbeat. GDP surprises were positive in Q3 for both the euro area and US, with the latter avoiding a third consecutive contraction in output. 
In addition, US and euro area inflation surprises are fading and reaching levels closer to normality. After a year of consistent upside surprises, the November data state a downside surprise for the US of -0.4, and a 0.4 surprise for the euro area.
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In Europe, this is coupled with a substitution away from Russian gas that was faster than predicted. Soaring energy prices were expected to imply much weaker growth and even sizeable economic contractions; but this has not proven to be the case so far, thanks to the accelerated substitution towards other suppliers, as well as a reduction in overall gas demand.
Labour market earnings data from the US rose by more than expected in November, however, flagging what remains a very tight labour market. If earnings data remain strong, they risk fueling so-called second-round effects, and generating a more persistent inflation overshoot.
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Ultimately, avoiding a recession will probably require a recovery in liquidity, followed by a rebound in consumer confidence. A prerequisite for this is likely to be an end to central bank tightening, which in turn requires clear signs that inflation is falling. It remains Fathom’s view that the tightening seen to date is probably already enough to tip both the US and euro area into recession, especially since monetary policy is traditionally assumed to take 18 months to have its full effect on inflation.
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Investors, however, seem to be taking an overall more benign view. The Fathom Macro Portfolios (FMP) — our proprietary set of indicators which replicate key economic series through liquid financial assets — allow us to track investors’ perceptions of key macroeconomic trends daily. Since the beginning of the year, FMPs indicate a normalisation in inflation surprises and a rebound in assets linked to the macroeconomic cycle. Liquidity, while it remains tight, demonstrates some signs of reaching a trough.
These developments tell us that investors have grown progressively less worried about inflation since central banks started tightening monetary conditions. The FMPs also show how liquidity has been driving market prices and macro conditions — since 2020, there has been a close relationship between liquidity and equity prices, and between liquidity and macro conditions. This recent phenomenon points to the conclusion that liquidity appears to be all that currently matters to investors. The key question for market participants is therefore: will there be a pivot?
Investors seem to think so, with recent moves in the FMPs suggesting that an expected recovery in liquidity will support economic activity. However, investors should beware looking beyond a recession before it has decisively started, and pricing in an imminent abundance of liquidity. The joint probability of both outcomes occurring is small, in our view, and conditional on a very benign outlook for inflation.
Looking beyond base effects, Fathom sees inflation easing more slowly than consensus. Moreover, we see a material risk (15% in the US and euro area, and 30% in the UK) of a continued loss of central bank credibility leading to spiralling second-round effects. In such a world, rates would need to go much higher, and economic growth would be pushed down much further, causing a significant reassessment of valuation and an abrupt end to the market rally.
The views expressed in this article are the views of the author, not necessarily those of Refinitiv
[1] Key charts from Fathom’s Global Outlook, Winter 2022, will soon be available to all Refinitiv users via Chartbook
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