It is said in the markets that being early is wrong. Given this maxim, it’s fair to say that pessimistic economists and market analysts have been wrong over the past two years.
Bearish forecasters began warning of a recession and associated sell-off in the stock markets as early as April 2022. Take, for example, a Reuters poll from October 2022, in which 65% of economists surveyed said a recession would come in the next 12 months. It was going to get ugly, and soon.
Fast-forward to today and the sun is still shining on the US economy. Unemployment is below 4%, inflation is falling, consumers are still spending, and the S&P 500 rose as much as 20% this year before cooling off recently. And GDP is expected to grow 1.6% in this third quarter, say economists polled by the Philadelphia Fed. Hardly any recession material.
Optimistic, sanguine economists are naturally seizing the opportunity to say, “I told you so,” as the consensus begins to sway toward their view that the economy will achieve a soft landing: lower inflation without the need for a economic shock such as a recession. Economists at Bank of America and JPMorgan are now saying there will be no recession this year, if at all.
But the fact that the economy’s flight path now seems calm doesn’t mean turbulence isn’t ahead. According to some of Wall Street’s top strategists and economists I’ve spoken to over the past few weeks, there is ample evidence that a recession is on the way. In other words, the bulls declare victory far too early.
“To say today we will have a soft landing is so premature,” Michael Kantrowitz, chief investment strategist at Piper Sandler, told me. “History teaches you that you really can’t make that assessment.”
Long and variable delays
The fulcrum on which much of the economy revolves is the interest rate policy of the Federal Reserve. Higher interest rates on various types of loans — mortgages, car loans, and credit cards — are hindering people’s ability to make purchases large and small, not to mention straining businesses’ ability to borrow. In theory, these higher interest rates depress demand and slow inflation by forcing companies to lower their prices to attract stretched customers. Lower interest rates are counterproductive and stimulate the economy by making it cheaper to borrow.
The rate hikes by the Fed over the past 16 months – from near zero to 5.5% – have always been central to the argument that recession is coming. The current cycle of rate hikes is the fastest and most aggressive since the early 1980s, and this historic increase in borrowing costs would dampen demand, slow consumer spending, hurt corporate profits and cost people jobs.
However, instead of this hard reboot, the economy has undergone a more soft reset. Inflation, as measured by the consumer price index, has fallen from its year-on-year peak of 9.1% in June 2022 to 3.2% in July. And Americans have been spending during higher interest rates: personal consumption spending and retail sales have continued to rise.
Sure, the economy seems to have shaken off the Fed so far, but experts say higher debt will eventually pinch. As the legendary economist Milton Friedman once said, interest rate changes have “long and variable lags”: it takes time for the changes to make their way to households and businesses. Bob Doll, chief investment officer at Crossmark Global Investments and former chief US equity strategist at BlackRock, told me the full impact has yet to be felt.
“To think that the only consequence is that a few banks go down for about a day and a half in mid-March, and then happily carry on, I think is a little naive,” Doll told me, referring to the collapse of Silicon Valley Bank and other regional banks.
David Rosenberg, an economist and founder of Rosenberg Research, was one of the first to feel the catastrophe that culminated in the 2008 recession. He has been calling for a recession since last year and told me that despite the more positive recent numbers, a recession is still coming. Rosenberg noted that the average time from the Fed’s first rate hike in a cycle to the onset of a recession is about 15 months — and the current cycle of rate hikes has been around for 16 months. But just like during the 2008 recession, things seem to be playing out over a slightly longer timeline in this cycle. When the economy entered recession in December 2007, it had been three and a half years since the Fed began raising interest rates in July 2004.
Rosenberg thinks the longer delay this time is due to fiscal stimulus that was aired during the height of the COVID-19 pandemic. The amount of support provided by the stimulus checks and other aid means people can tolerate higher interest rates for a while and consumers can take a more “YOLO” (you only live once) attitude about their spending. But eventually, this attitude will diminish as people realize that the higher rates are not a flash in the pan. Even now, the number of Americans falling behind on their credit card debt is starting to rise — 7.2% of credit card debt is now considered past due, up from just over 4% in 2021. In the wake of the Great Recession, that number has reaches a level of about 14%. The number of delinquencies on car loans and mortgages is also increasing.
For others, the delayed effect of inflation itself will weigh on consumers and push the economy into recession. Tom Essaye, the founder of Sevens Report Research, which counts some of the largest institutions on Wall Street among its clients, said that while annual inflation has fallen significantly, the cumulative price increases we’ve seen since the crisis started the pandemic will ultimately force consumers to cut back on their spending.
“People get really excited about the CPI and say, ‘Hey, the CPI just went up 0.1% last month and only 3% last year,'” said Essaye. “Well, think about that in practical terms. If I’m going to buy a bag of skittles for my kids, it cost $0.75 in 2019. Now it costs $1.50. Should I get excited because next year it’s $1 .55 costs?”
The wheels of industry are slowing down
Piper Sandler’s Kantrowitz pointed to another concern: production. Industrial production, a measure of how much stuff is coming out of US factories, is on a downward trend. And surveys of manufacturing managers, such as the Institute for Supply Management’s Purchasing Managers Index, reveal widespread concerns across the industry. Even after the industry has taken a hit, rate hikes are still feeding into manufacturing data. A causality test by Granger, which establishes the highest point of correlation between two data sets, showed that it typically takes about 18 months for rate hikes to fully show up in manufacturing data. That means there are likely even more downsides ahead. While manufacturing is just one component of the U.S. economy, experts say it’s important to pay attention because it reflects consumer demand and is therefore a gauge of the wider economy.
Another delayed effect of the interest rate hikes is the impact of tighter credit conditions: even if consumers and businesses are interested in taking out loans, banks must be willing to provide them. According to the Fed’s Senior Loan Officer Opinion Survey, more than half of banks are tightening credit standards for businesses, as evidenced by the supply of commercial and industrial loans, which have fallen since December. When this happens, it could mean that banks become more concerned about borrowers’ ability to pay back the loans amid economic uncertainty. Companies use these loans to grow and pay employees, which means that a decline in loan issuance weighs on employment and business growth.
But Kantrowitz and Rosenberg are not alone in thinking policy gaps persist. Rosenberg pointed to statements made by Fed Chairman Jerome Powell at a press conference in July: “We’ve covered a lot of ground and the full effects of our tightening have yet to be felt.”
Lagging realization for investors
Of course, there have been times when the Fed has raised rates without triggering a recession. But these examples are anomalous: 80% of Fed hike cycles since World War II have resulted in a recession. Not an encouraging track record.
There is one key differentiator, Rosenberg said, that will indicate whether the economy is headed for a true soft landing or into recession: the interest rates on different types of government bonds. The government bond yield curve measures the different interest rates paid on different bonds issued by the U.S. government. Typically, yields on short-term government bonds — bonds that pay investors in less than a year — are lower than yields on longer-term bonds, such as the 10-year Treasury bond. But if that turns around and interest rates on short-term government bonds are higher than their long-term bonds — known as a yield curve inversion — that’s a clear sign of a recession, Rosenberg said. That is because it is a sign that investors are concerned about the stability of the economy in the coming months and are seeking safety in long-term bonds. Interest rates and the curve have inverted since late last year. Since the 1960s, the indicator has a perfect track record of previous recessions.
If a recession does come, investors are likely to face a difficult period. As Rosenberg put it, “the stock market is priced for perfection.” And there are many indications that this is true. Sentiment indicators and valuation measures currently show that investors expect continued growth. Kantrowitz pointed out that this year’s rally is one of the sharpest in the last 25 years, but that it is separate from fundamental factors. For example, the market is growing enormously, despite the fact that profit expectations are negative and production is still in contraction territory. It’s the same story every time, both Kantrowitz and Rosenberg say: Investors are bad at judging a recession before it unfolds.
How much stocks fall in a recession scenario likely depends on the depth of the downturn. For example, Doll sees only a mild recession ahead and therefore expects the S&P 500 to likely fall another 13%. But over the past 13 recessions, the S&P 500 has fallen an average of 32%, as the Royal Bank of Canada noted.
Based on the current strength of the market, despite a recent summer slumber, most investors believe the optimists are right: inflation will remain low, the labor market will hold up and the effects of rate hikes will be visible. rearview mirror. But when markets get complacent, Kantrowitz said, “people have historically gotten into trouble every time.”
William Edwards is a senior investment reporter at Insider covering the U.S. stock market and economy.
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