Recession: Indicators Say Not Yet
Most of my readers know I use three current indicators to give a warning of an upcoming recession. These three indicators are the shape of the yield curve, the rate of change of the LEI (leading economic indicators) and the status of both the manufacturing and services PMI indexes. These three indicators have, historically, given us an early warning of a possible economic recession. We aren’t forecasting a recession this year, as only one indicator is currently flashing yellow (yield curve). The other two, while they have deteriorated lately, are not yet flashing yellow or red. This leaves us with our disciplined view that we are probably not going to experience a recession in 2022.
That said, we are noticing several economic momentum data points that are pointing in a decidedly negative direction, indicating a slowing in overall economic vitality.
- While still positive, the LEI is trending toward economic contraction. While not yet -3% over the last six months, which is our barometer reading of the LEI indicating an upcoming recession, the index is weakening, which suggests further weak overall economic momentum should be expected.
- Existing home sales are falling. Growth isn’t slowing—existing home sales have stalled and are falling, being pushed down by the rise in home mortgage rates. The following are recent data points regarding housing activity1:
- New home sales have recently fallen by 19% to their lowest level since April 2020.
- Mortgage applications have fallen as have existing home sales.
- 30-year mortgage rates have risen in the last five months from 3.11% to 5.1%, a significant increase in a short period of time.
- Of the nation’s 392 major housing markets, 96% of homes in those markets are “overvalued” when considering mortgage costs in relation to household incomes2.
- Along with this data, home-builder sentiment has deteriorated. “Housing leads the business cycle, and housing is slowing,” said NAHB Chairman Jerry Konter, a builder and developer in Savannah, Ga3. Index results on current sales, sales expectations and buyer traffic have all declined.
- Truck orders have fallen. In April, Class-8 (large) truck orders came in at 15,800 units, the first time this monthly data fell to less than 20,000 since last year.
- Retail sales (real) have recently fallen. People are spending more share of wallet in the grocery aisles as food inflation is hurting disposable income levels for all, particularly impacting lower-income families4.
- Unemployment claims are slowly ticking upward.
- PMI indexes, while not yet at troubling levels, have recently weakened.
- Corporate credit spreads are widening.
- With the stock market decline, some are starting to consider consumption impact on those fortunate enough to own stocks. J.P. Morgan reports that consumer spending typically is cut by 2% for every dollar decline in financial wealth5.
- As stock market capitalization has declined by $8 trillion since the first of the year5, analysts are now suggesting that the “wealth effect” of the current decline may pinch consumption by $160 billion, not a small sum.
To top off this list of growing economic issues, the Federal Reserve (Fed) will launch QT2 (quantitative tightening) actions next month. Its current plan is to let bonds “roll off” its balance sheet, bringing further pressure to the Treasury Department to find other purchasers of the seemingly never-ending hunger for lenders to step up and finance government deficit spending.
What does QT2 look like? The chart below shows the fed funds rate (short-term interest rates) in a historical context. Note the increase in the fed funds rate during the previous period of quantitative tightening (QT1), rising from a little over 1% to almost 2.5%.
The Fed’s plan for QT2 is to start in June with an expected runoff rate of $47 billon per month for the first three months, which will be reportedly followed by a monthly $95 billion runoff, with no announced end in sight. As stated, this is a twice as rapid bond holdings runoff than was the case during QT1, which occurred from 2017-2019.
Many remember the stock market’s “tantrum” during QT1, when investors realized the Fed no longer had the stock market’s “back.” The “Fed put” had expired, and markets swooned. Will the same occur during the upcoming round of quantitative tightening? We will see.
Raising Recession Probability, Lowering Soft Landing Chances
Our thematic economic outlook for 2022 has been calling for three probable scenarios/focal points: a 50% probability of “stagflation” being the key economic environment for this year, a 30% probability of the Fed engineering a “soft landing” and a 20% probability of the Fed missing the mark and creating a “hard landing” (recession).
Given the recent economic softening evidence noted above, we are changing the probability that the economy will experience a hard landing, or recession, in 2022 to 30% from 20% and reducing the probability of a soft landing to 20% from 30%. Remember, the U.S. economy has been in recession 12% of the time since the end of WWII. We suggest the probability that we will experience a recession this year to be more than two times the normal risk level of an outright contraction. While we continue to believe the economy will not stray into a recession this year, the probability of such is rising.
Likewise, it is important to understand that within our “core” economic case, we are still calling for positive gross domestic product (GDP) growth this year. Unfortunately, we continue to call for a higher-than-normal level of sustained inflation pressure for the remainder of 2022. Stronger-than-normal inflation will probably continue to be a worry until we see the economy shift gears into reverse with the onset of the next recession, whenever that happens. As our old friend Dr. Bob Dieli, editor of the “No Spin Forecast,” likes to say regarding stagflation, “‘Flation’ tends to give way to ‘stag.’” We should expect to see inflation pressures subside rather rapidly during the next economic downturn.
Powell Isn’t Volcker
It is important to highlight our view that if the markets contract meaningfully as a result of the new QT2 monetary policies, we suspect Chairman Powell may reverse course or suspend QT activities.
This hasn’t always been the case. In the late 1970s, the Federal Open Market Committee was chaired by the legendary inflation-fighting Paul Volcker. In 1979 when Volcker became chairman, GDP growth was 3.2%, the same as the long-term average, but inflation was 11.3% (much higher than normal). In April 1980, Volcker raised the fed funds rate to 10.25%, attempting to address the inflation problem. But Volcker had just begun.
By March 1981, the Fed had increased interest rates to 20.0%, bringing on the deep recession of the early 1980s. By dragging the economy into recession, Volcker was successful in his inflation-fighting efforts as the U.S. economy ushered in a new deflationary environment that by and large stayed on the scene for the next 35 years. But it was a painful economic experience.
When Volcker was chair, Ed Yardeni, upon graduating with his Ph.D. from Yale, went to work at the New York Federal Reserve as a staff economist. Ed has said he got to know Volcker and his attitude toward inflation pressures. Ed has commented that Jerome Powell isn’t Paul Volcker. In Ed’s opinion, Powell doesn’t hold Volcker’s hardline view of the Fed’s “price stability” mission. Consequently, if things don’t go well, Powell may very well reverse course.
We entered this year with the thought that 2022 might go down in the record books as a year of heightened financial risk, with volatile capital market pricing swings. We now believe that 2023 may be recorded as a year of heightened business risk.
So, we think recession risks are building. This isn’t to say that we think a recession will occur in 2022. Indeed, we continue to think our stagflation story will dominate the economic environment this year. With this outlook, our thoughts are:
- Real GDP growth will be positive this year but lower than the 3.2% historical norm. We continue to believe GDP growth will run around 2.5% for 2022.
- Inflation will remain an economic and market driver this year, with more impact than the historically normal rate of 3.7%. We are now suggesting inflation rates will recede to around 6% as the year continues to unfold.
- The economy will avoid an outright recession, but the probability of a Fed policy error seems to be rising. Remember, the economy normally runs into a recession when the Fed’s monetary policies are too tight, for too long, ushering in a credit squeeze.
- The job market should remain reasonably sound.
- Corporate profit growth should be positive.
- Housing starts should remain flat to down.
- If worker productivity gains traction, it could act as an antidote to wage (cost-push) inflation, as employers don’t see the need to raise prices as aggressively.
- The Fed will step up its inflation-fighting efforts, driving interest rates higher. We expect to see fed funds trade at 3.0% by the end of the year (currently at 1%).
- If inflation remains a problem, we suggest the Fed will move short-term rates into restrictive territory sometime in 2023. In this case, we target fed funds at 4% next year.
On balance, we continue to expect a positive economic growth profile to persist this year. But the Federal Reserve’s monetary policy is changing. Higher interest rates and the onset of a new round of quantitative tightening will affect economic activity and provide fodder for the capital markets.
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