Economic conditions might seems prime for investment, but with a recession on the horizon, Cormac Lucey recommends looking at the global economic outlook before you make any decisions.

Capital allocation is a senior management team’s most fundamental responsibility, according to Michael J. Mauboussin and Dan Callahan in their essay “Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance”. 

Capital allocation is always important but is imperative today as the return on invested capital is high, growth is modest and corporate balance sheets have plenty of cash. 

Unfortunately, there is one key risk on the horizon today that may upend many investment decisions: the prospect of a global economic downturn. 

Recessions are one of the most significant risks that confront senior managers. They weaken financial performance and cause company values and share prices to drop. Suppose those drops are accentuated by expensive investments or acquisitions made on the eve of a recession. In that case, they can unleash a search for managerial scapegoats that lead to executives departing their positions “to pursue other interests”. 

However, whether one looks at the USA, China or the eurozone, the immediate economic outlook is gloomy.

GDP growth has gone negative in America, which recorded an annualised -1.4 percent rate in the first quarter, and that’s before the Federal Reserve’s interest rate tightening campaign began to bite. 

April’s US consumer price index surprised on the upside, with the core measure rising 0.6 percent month-on-month, or 6.2 percent year-on-year. With monthly price rises at this level, it will be difficult for elevated base effects from last year to decrease the annual inflation rate. That high inflation data came shortly after labour market reports showed a 20-year record for the ratio of job vacancies to numbers unemployed. 

This recent data is only likely to harden the Fed in its resolve to choke inflation out of the US economy. Bill Dudley, a former President of the Federal Reserve Bank of New York, recently warned investors to pay closer attention to the words of Jerome Powell, Chair of the Federal Reserve (Fed). 

“Financial conditions need to tighten. If this does not happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower,” Dudley stated.

The situation in China provides little comfort. Whereas its economy often provides a counterweight to US influences (growing fast when the US is growing slowly and vice versa), the Chinese authorities’ zero-COVID-19 policy is choking economic activity. China could already be in a recession. 

Shanghai’s port activity is falling faster than in early 2020, when the COVID-19 outbreak caused the entire global economy to shut down. Chinese purchasing manager index measures have already fallen well below 50, signalling a contraction in activity levels. 

In Europe, inflation has also become too uncomfortable for the European Central Bank. President Lagarde has said that quantitative easing will end in Q3, and interest rate hikes will likely commence at the ECB’s 21 July policy meeting. 

However, this year, the eurozone first-quarter growth was a measly 0.2 percent over the previous quarter. The war in Ukraine has directly affected energy supplies to EU economies, forcing many to seek alternative, and costlier, sources.

With recession looming, be careful not to make significant investment decisions you might later regret.

Cormac Lucey is an economic commentator and lecturer at Chartered Accountants Ireland.