What’s Ahead for the Markets: Recession or Stagflation?

November 3, 2022
What’s Ahead for the Markets: Recession or Stagflation?

As most of you know, I suspect we will see a light recession unfold over the next six months. I believe the probability of such an outcome is somewhere north of 50%. If a recession doesn’t occur, I suspect we may see a continuation of the stagflation environment, which has been the dominant macroeconomic theme for much of this year.

Beyond those two economic scenarios, the other possible outcome for economic activity is for the Federal Reserve, through its monetary actions, to create an economic “soft landing,” a heroic result that, when the Fed is aggressively raising interest rates, has seldom been accomplished.

US recession probability model

When Could a Recession Occur?

Many economists are calling for a recession to happen sometime over the next 12 months, so I’m not alone in my call that a recession may indeed occur in 2023. The Conference Board’s recent economic modeling (see chart) suggests that there is a 96% probability the U.S. economy will experience a recession in the next 12 months. 

Frankly, I don’t know whether the odds of a recession are 96% or 50% but remember the U.S. economy has only been in recession 12% of the time since the end of the Great Depression.1 One way or the other, our discipline and tools say the odds of a recession are much higher going forward. And in my estimation, that outcome is the more probable and even preferred outcome than a grinding, slow stagflation environment of higher-than-normal inflation combined with lower-than-normal growth.

So, this is bad news, right? Not necessarily. The Fed tends to “engineer” recessions by being overly aggressive in monetary policy applications. Recessions just don’t normally happen out of the blue.  Recessions occur for reasons—usually because something is out of balance in the economy. This time around, we have too much inflation, which needs to be exorcised from the system. Inflation won’t simply go away unless something changes. These changes can happen in one of two ways. 

High Inflation Reflects Economic Imbalances

Inflation occurs when final demand growth is higher than supply growth or when supply and demand are out of balance. Prices rise when this occurs. The only two ways to affect this relationship and soften inflation pressure is to either increase supply growth or reduce demand growth, or both.  

Enter the Fed and its policies. The Fed can’t easily directly impact supply growth, but it can impact demand growth through reducing the supply of liquidity in the system, which raises the cost of capital, i.e., interest rates increase, which softens demand growth. See the housing market for an example. 

Some say we haven’t seen evidence of a recession, which is largely accurate. But we have seen changes in the bond market and the leading economic indicators that, based on historical standard, strongly suggest the risk of an upcoming recession is higher than normal. These are two tools that I have used in the past to raise the specter of an upcoming recession. These two tools (shape of yield curve and the momentum of the leading indicators) are indicators that have had a strong track record of front-running an economic downturn. This is undeniable.

People also believe that the Fed’s policies are not yet working because inflation has yet to decline dramatically, even though the Fed has raised short-term interest rates from around 0% to 3% over the last seven months. We need to remember that moves by the Fed to tighten money supply (by raising interest rates) don’t show up in changes in final demand for six months or so. There is a lag between economic activity and Fed policy changes. With this in mind, the Fed’s initial rate increase occurred in March of this year, a mere eight months ago. Rates increased by .25% at that time.  Since then, the Fed has raised rates by another 2.75%, most of which hasn’t impacted final demand growth rates yet. That impact may indeed be forthcoming.

It is also undeniable that the economy grew in the third quarter of this year, so those who have been suggesting that the economy is currently in recession are also wrong. This places us in no-man’s-land, where we see building risks leading to an economic downturn, but we also see the current environment where final demand growth rates remain reasonable.

No Lessening in Fed’s Favored Inflation Indicator – Yet

What is the current state of inflation? Recently, the Bureau of Economic Analysis (BEA) released its data for the Personal Consumption Expenditures Price Index (PCE) in September. This is an important data stream, as this is the Fed’s favored inflation measure, not the much-followed Consumer Price Index (CPI). 

During the month, the core PCE percentage change was +0.5%, and the “all-in” PCE rate of inflation was +0.3%. The year-over-year PCE growth rate is 6.2%, up from 5.9% from the previous month’s release.  Due to the lack of progress to weaken inflation pressure, it appears the report punched the Fed’s ticket to raise the fed funds rate by 0.75% to a range of 3.75%-4.00% during the next meeting and to retain a “hawkish” stance toward monetary policy. 

Within the same report from the BEA, personal income rose by 0.4% for the month, while consumer spending rose by 0.6%. It appears that savings rates and/or credit card usage made up the slack. The trend of consumer spending not being covered by current incomes has been occurring for some time now. Unless income growth rates accelerate spending, growth will need to eventually contract. Also note that incomes continue to grow more slowly than inflation. While spending rose by 0.6%, a case can be made that most of this occurred because inflation remains high (consumer spending is stated in “nominal” terms and isn’t adjusted for inflation pressure).  

Recession Most Probable Forecast

I am not cheering for a recession to occur but rather am cheering for inflation to recede, either through a slowing in demand growth or by an increase in product and services supply rates. Either will bring inflation down. 

Contracting final demand growth rates risks bringing on a recession. While not pleasant, that is the silver lining of a recession—that pricing pressure, if it is in excess, will contract due to the fact that final demand growth rates will also contract. At this stage, a short recession may be the easiest, most sure way to soften inflation pressure. While I am not cheering for a recession to unfold, it may be the quickest, easiest solution to a deeper, more broad problem—that is, a high, destructive inflation environment. I believe people shouldn’t fear a short, sharp recession. They should, however, fear a long, drawn-out period of sustained inflation pressure. A recession is the lesser of these two evils. 

If we don’t see a slowing in final demand growth rates, and we stay out of recession, I fear high inflation will remain on the scene, and the Fed will continue to raise interest rates well above our now-forecasted 4.5% fed funds rate. How high will interest rates become? That will be determined by how high inflation remains and for how long inflation is perceived by the Fed to be an issue. 

Consequently, if we don’t see a reduction in final demand and possibly an outright recession occur, the Fed will likely continue to tighten monetary policies, driving rates higher than many currently expect. 

Soft Landing Possible?

Why do I believe a soft landing—a period of sustained economic growth combined with lowering inflationary pressure—won’t occur? Why won’t we see the Fed usher in a “Goldilocks” (not-too-hot and not-too-cold) outcome? This type of outcome is possible, but historically when the Fed is in a tightening mode, this type of outcome (soft landing) has normally not occurred. 

The Fed has launched nine rate-cycle increases since 1961. A recession followed those rate increases eight times, which shows the Fed’s track record of raising rates and creating a “Goldilocks” or a soft-landing scenario has been about 12%.2 Indeed, the New York Fed’s own monetary modeling released earlier this summer shows a mere 10% probability that the Fed will succeed in its efforts to cool inflation without creating a “hard economic landing” outcome.

History tells us that the Fed’s capability of raising rates on a sustained basis without ushering in a recession has been poor.

My Outlook

My outlook is calling for the Fed to raise fed funds (short-term) interest rates to 4.5%-5.0% by the end of the year and then shift to a “wait and see” attitude. If inflation cools, the Fed may not raise rates significantly in early 2023. Under this scenario, economic recession may be in the cards for 2023, but the recession would probably be light and short. Corporate profits may not see a major downturn, and longer-term interest rates would start to decline.

As outlined, a short recession may indeed be the favored, highest probability outcome going forward.   

Sources:

1National Bureau of Economic Research

2Piper Sandler, 3-25-22 report

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