Recession? Income Statement, Yes. Balance Sheet, No.

The financial world was all abuzz earlier this year about inflation. Now that the Federal Reserve has raised rates by 0.75%, Wall Street’s focus has shifted to recession. 

Let’s see—inflation and recession—sounds like stagflation. This is what we have been focused on over the last year and what has been our “core” outlook for the last number of months. 

Now, it seems like we can’t open the paper or turn on our computer without finding another forecaster or economist “discovering” the high probability of an upcoming economic contraction. We read “look at retail sales, look at Walmart’s announcement” or “look at housing starts and housing prices.”

Yes, without much doubt, the economy is weakening. Not only the U.S. economy—but it looks like the central powers in Europe are also on the ropes. Germany, France and the U.K. all look like they are heading toward economic contraction, and China can’t seem to get out of its own way.

Broad Global Economic Slowdown

The IMF has recently lowered its global economic forecast. It now believes that U.S. economic growth is slowing and will continue to slow. It suggests that U.S. economic GDP will only grow by 1% next year. Additionally, the IMF says China’s growth won’t be higher than 3% this year—a very low number for them. Europe may experience a broad-based economic contraction. I’ve been suggesting that in a world of stagflation, “flation” eventually gives way to “stag.” Indeed, this seems to be occurring globally. Welcome to the world of supply and demand, where the cure for rising prices is rising prices. 

We are carrying a 50% probability of the U.S. slipping into recession this year. Our “baseline” probability over an entire cycle of experiencing a recession has been 12% (this is how often the U.S. economy has been in recession since the end of World War II.¹) Recession has historically been the shortest of the four parts of the typical business cycle (recovery, expansion, boom and recession) at an average of 11 months in duration.² So, if we slip into a recession this year, I suspect by this time next year the recession may very well be over. 

Out of Balance? Recession Is the “Fix”

Recessions occur for a reason; they don’t just happen. They occur because, economically, something is out of balance. The economy has too much or too little of something. The economy had too much unserviceable debt prior to the Great Recession, which occurred from 2007-2009. That debt structure needed to be rationalized. 

This time around, we have too much inflation. If we indeed experience a recession over the next year, it will probably be viewed in the economic history books as a reaction to inflation pressure, which arguably was irritated by government spending policies and underwritten by wrong-footed Fed monetary actions.  And, massive government spending programs financed by “printed” money has a downside risk. We are seeing that downside now, with a strong bout of stagflation. Milton Friedman was right—there are no free lunches, and from an economic standpoint, there are no solutions, only trade-offs. 

State of Affairs—GDP Report Flashing Weakness

Indeed, we have now seen two straight calendar quarters of negative GDP. GDP shrank by 1.6% during the first quarter of the year, and the initial report for the second quarter shows GDP declined by another 0.9%. By a “back-of-the-envelope” calculation, many suggest the economy is already in recession. I think it still too early to make the recession call, but the bricks are being laid for just such a call. 

Now, the folks at the National Bureau of Economic Research (NBER), who officially make this call, say a recession doesn’t occur unless economic weakness is “deep, broad and long.” The NBER doesn’t forecast recessions—it simply reports that one is present. To do so, it needs to see enough evidence, which is backward-looking, to become convinced that an economic downturn has actually occurred. 

Digging down into the first and second quarter GDP report, we find that final sales (consumption and business investment) were strong during the first quarter of this year at +3%. The weakness in the economy during the first quarter was centered on net imports (they were high and a depressant on economic growth). Inventory build, a temporary factor, was also pervasive. So, the weakness we saw that quarter wasn’t broad in its effect, even though the GDP report showed U.S. GDP growth at -1.6%.

That said, the first release covering first quarter GDP data shows the economy shrank by 0.9% and final sales grew by 0%, down from +3% in the first quarter. With this in mind, the economic weakness in the second quarter was real and more meaningful than what we experienced during the first quarter. While it’s too early to make the call that the economy is currently in recession, evidence of recession is certainly building. The weakness we are seeing has become broader and deeper but, so far, isn’t yet “long,” failing in the NBER’s definition.

Irrespective of definitional details, the economy is showing signs of weakness and stress, as growth is weakening on a rather broad-based level. As we move into the second half of this year, I suspect we will see unemployment trends push to the upside as the contraction spreads.     

The Fed Has Been Busy and Will Remain So

In its attempt to lower inflation pressure, the Fed raised the federal funds rate (short-term interest rates) by 0.75% recently, bringing that key rate to 2.35%. Fed Chairman Jerome Powell said that the fed funds rate has now reached “neutral”—an important statement. This suggests the Fed will start to slow its rate increase process. It has been targeting a neutral fed funds rate position by the end of 2022 and apparently has reached that point. 

A neutral fed funds rate is equal to underlying inflationary pressure. Does this statement suggest that Chairman Powell believes the sustainable core inflation rate to be 2.35%? No. We need to consider the negative effects of the Fed’s QT (quantitative tightening) actions when thinking of a neutral fed funds rate. Ed Yardeni, president of Yardeni Research, believes, and I concur, that QT actions are effectively acting like the fed funds rate is 0.50% higher than current, as QT is acting as another depressant on economic activity. So, if we combine the current fed funds rate with the monetary effects of QT, Fed policy, and not just interest rates, is currently close to being neutral.  

By my statement above, I am suggesting the Fed is no longer behind the curve when comparing monetary policy to underlying core inflation. To cool overall inflation pressure, the Fed will need to move into a “restrictive” policy stance. The risk of moving into a restrictive stance, which should bring inflation pressure down, is that it will occur at the cost of economic growth. Consequently, as the Fed continues to raise interest rates (which I think may eventually hit above 3%, up from the current 2.4%), economic growth will slow further, bringing on more intense pressures for a recession to become reality.

The good news about a possible upcoming recession is that inflation pressure will probably shrink. I continue to suggest we will see “all-in” inflation at about 6% by the end of this year, down from the current annualized 9.1% read. Fed monetary tightening policies should work, but as Milton Friedman said, in economics there are no solutions—only trade-offs. The trade-off for lowering inflation pressure is economic weakness. Currently, the Fed’s policies are adding to economic softening pressures. 

Will we see a “soft landing,” reducing inflationary pressures and at the same time avoiding a recession? I guess anything is possible, but in this regard, hope flies in the face of experience. In my opinion, the probability of experiencing a soft landing is rather remote.     

Our Key Indicators Are Flashing Yellow or Red

I stand by my view that the risk of recession is now higher than normal. I have written at length about our three key recession-watch indicators. Two of the three, the yield curve and Purchasing Managers (PMI) Index, are now suggesting an upcoming recession is in the cards. The other six-month rate change of leading economic indicators (LEI) is moving quickly in the wrong direction but has not yet called for an upcoming economic contraction. With two of our indicators flashing red, we should brace ourselves for further economic weakness. 

Recession—What Shape?

So, if we move into recession, what should we expect? 

Historically, there have been “deep” recessions and more “shallow” recessions. Based on historical standard, the following tend to be some typical economic results that may occur during a recession:

• GDP moves into negative territory on a consistent, broad-based level over a period of time.  This is reflective of:

• Inflation cools as growth in final demand lessens.
• Savings rates eventually rise as growth in consumption slows. 
• Debt-level growth slows and, in many cases, reverses as people pay down debt. Default levels also increase. 

Of the items above, the first two main bullet points (GDP and inflation—or stagflation) are pressures that both weaken during a recession. Economic growth cools as does inflation. We can classify these two pressures as income statement items. This is where our excess currently resides—on the income statement side of the economy.      

The last two items (savings and debt) tend to focus on mending balance sheets and not on the national income statement. These items (lack of savings and too much debt) were out of balance prior to the Great Recession of 2007-2009, a deep, painful recession. Balance sheet recessions tend to be very painful to fix; income statement recessions, not so much. Prior recessions that focused on income statement imbalances include the recessions of 1990 and 1981.³

1990: GDP declined by 1.1%, and unemployment increased to 7%. 

1981-1982: GDP declined by 3%, and unemployment increased to 10%. 

Of these two earlier examples of income statement recessions, GDP contracted by an average of 2.0%, and unemployment rose to 8.5%. What of the Great Recession that focused on economic balance sheet problems? 

2007-2009: GDP declined by 4.3%, and unemployment increased to 10%.

While we only show one example of a balance sheet recession, you can see that previous income-statement-oriented recessions have been half as deep, and unemployment, on average, didn’t reach the heights reached during the Great Recession. 

Recession—If It Occurs—Should Be Less Damaging Than the Great Recession

If we do slip into a recession, I suggest it will be shorter-lived and weaker than the recession many of us remember: the Great Recession. From a capital market timing standpoint, we need to remember that stock markets tend to rally—hard—during the last half of earlier recessions as the Fed stops raising interest rates. Also, stock prices tend to rally upward when the NBER finally makes the recession call, realizing that yes, at that point, we will have been in recession for quite some time.

Our call for GDP growth in 2022 remains at 1.5% for the year as compared to historical long-term growth of 3.2%. We have yet to make a formal call for GDP growth in 2023, but we are also of the mind that the Fed will succeed in its actions to lower overall inflation pressure, as we are expecting to see 6% inflation by the end of this year, down from the current 9% rate. We also think the Fed will slow its actions on raising interest rates for the rest of this year.

We have been targeting the fed funds rate to increase to 3% by the end of the year. We are now at 2.3%. The Fed has three more meetings this year. I expect to see some kind of combination of rate increases by the beginning of 2023 of another 50-75 basis points. The Fed is, in my opinion, just about done raising interest rates. It has raised rates by a total of 235 basis points so far this year. Following another 50- or 75-basis-point rate increase, the Fed will probably sit back and see how the economic growth and inflation fare following the current tightening cycle.    

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Sources:

^{1, 2}National Bureau of Economic Research

³CNBC Data

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