A US recession is on the table

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Hello. I am tanned, rested and ready after a week of fishing. Before I left, it was pretty clear that the war in Ukraine would lead to a Russian depression and a European recession. When I returned, however, the possibility of a recession in the United States had been added to the menu of possibilities, as an unlikely, but not very unlikely outcome. Today Ethan and I review what has changed. As always, we’re eager to hear the opinions of readers: [email protected] and [email protected]

We need to talk about an American recession

Here is the outlook from our favorite Wall Street economist, Don Rissmiller of Strategas:

Our base-case scenario is a mid-cycle slowdown in 2023 (50% probability) as the private sector helps the Fed get inflation under control (e.g. bottlenecks ease). With a still strong domestic labor market and high JOLTS job openings, it remains difficult to make a US recession our base case scenario. Yet, if the Fed over-tightens, growth will weaken (35% chance). An upside surprise case would imply increased productivity and robust growth (15% probability).

About a third of the chance of a recession is what Goldman Sachs economists are also considering:

While our baseline forecast assumes that the continued reopening of the service sector and excess savings spending will keep real GDP growth positive over the coming quarters, the uncertainty surrounding the outlook is higher than normal. , and we consider the risks of a recession to be broadly consistent with the 20 -35% odds currently implied by models based on the slope of the yield curve

High probabilities but less than 50% are hard to imagine. The temptation is to throw a 35% possibility into the improbable bucket and forget about it. But if it does happen and you’re unprepared, just blame yourself.

What has changed so that the possibility of a recession in the United States is taken seriously? Oil prices, which have risen 30% in just over two weeks, are likely the main focus. Wheat and corn prices, up 17% and 10% respectively over the same period, are not helping much either. But the rumors of a slowdown go beyond commodities.

A bit of context first. Remember that the dizzying growth of early reopening quickly fades. The consensus seems to be that the economy is approaching its long-term trend rate. The Atlanta Fed’s real-time GDPNow estimate for current quarter growth is just above zero. And that’s before – long before – the impact of rising commodity prices could penetrate the economy:

We’re just not that far from a shrinking economy. Consumers and market participants know this, which unfortunately only makes a contraction more likely.

Michigan’s latest consumer sentiment survey reading hit a new post-financial crisis low. This is not surprising, given that inflation is keeping real wage growth negative.

Yes, the yield curve remains positive — just:

Line chart of 10-year Treasury yields minus 2-year Treasury yields showing You call that a curve?

But credit markets, while still loose by historical standards, are tightening at a steady pace. It does appear that corporate bond traders believe economic conditions could worsen. Here is the spread of BBB bond yields (the lowest rung of investment grade) over Treasury yields:

Line chart of ICE BofA BBB US option adjusted spread showing risk puff

Strong corporate earnings have supported the bullish scenario for equities during this year’s turmoil. But this chart from Citi’s equity strategy team shows that analyst earnings revisions, overwhelmingly positive just a few weeks ago, are roughly evenly split between ups and downs:

At the same time, no one should expect slowing growth, weak consumer confidence, flattening of the yield curve, widening of spreads or downward revision of earnings scare the Fed off the path to higher rates. What we see in the United States is probably best characterized as a return to normal activity levels from feverish peaks. Given recent CPI numbers, that’s not enough to make the Fed back down. According to Bloomberg, the market expects nearly seven quarter-point key rate hikes by the end of the year. The Fed won’t save the day unless things get worse.

There are good reasons, however, that if the risk of a recession increases, few observers consider it their base case scenario. Although analysts raise their estimates less often, the earnings picture still looks decent. Forecasters expect S&P 500 earnings per share to rise 17% over the next 12 months, according to data from Bloomberg. Recent surveys suggest that companies are reacting to rougher waters by protecting their margins with price increases. Capital expenditure also remains strong.

More importantly, it’s hard to see a recession taking hold when the job situation is so strong. The growth in the wage bill and in labor market participation has been accompanied by significant nominal wage gains. And although the data is a little old, it seems that these salaries are being spent. Consumer spending and retail sales rose 2.1% and 3.8% in January, respectively. Meanwhile, Congress passes a $1.5 billion bill that approves new spending for the military, schools, housing, and other projects. Tens of billions of new government demands could turn the US fiscal stimulus – which has been a drag on growth recently – positive.

Given all of this pre-existing strength, a commodity shock large enough to trigger a recession should indeed be severe. Judging by historical rules of thumb, Michael Pearce of Capital Economics believes oil would need to stay above $200 a barrel to cause a slowdown. Possible, but the risk is well telegraphed. This may present a buying opportunity, Goldman Sachs strategists argue in a recent note:

when the US economy avoids recession, corrections of 10% and more in the S&P 500 generally represent good buying opportunities, with a subsequent 12-month median return of 15%

If we use Rissmiller’s probability estimates, there’s a 35% chance that buying a stock is a bad trade, 50% that it works, and 15% that you’ll pass yourself off as an outright bandit. Getting compensated for taking a risk – so old fashioned.

For a long time, American investors in general, and American equity investors in particular, have been heavily shielded from risk – by fiscal and monetary policy, the steady economic recovery from the Great Financial Crisis, and the bottomless global appetite for American assets. The growing likelihood that economists, analysts and pundits are placing on a US recession shows that risk is returning to the markets. The process of accurate risk pricing, after this long vacation, is likely to be a long and unstable process.

A good read

Russian student and Stalinist biographer Stephen Kotkin in conversation with David Remnick.

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