Forbes.com:
Investors are more and more confident that the U.S. economy can avoid falling into recession in 2023. This so-called “soft landing,” the sweet spot between cooling inflation and a still-growing economy, appears to be a real possibility.
Nevertheless, threats remain to this rosy scenario. Inflation has trended consistently lower for months, but interest rates are at 20-year highs and a handful of economic indicators suggest the economy isn’t out of the woods just yet.
The New York Fed recession probability indicator shows there is still a 66% chance of a U.S. recession in the next 12 months. Other reliable indicators are flashing warning signs that the economy could still slump: Jobs data has started to fade, the yield curve remains inverted and experts are divided on whether a recession may have been delayed rather than avoided entirely.
The Federal Reserve has warned over and over that its long campaign of rate hikes will slow economic growth, even if its most recent economic projections no longer foresee a recession. And just because the risk of a recession is fading, interest rates will remain higher for longer, meaning that investors should take a cautious approach to the market.
Even if the U.S. ultimately avoids a recession in 2023, the Fed’s aggressive monetary policy strategy from the past year and a half may only now be starting to have a negative impact on the economy.
What Is a Recession?
There is no universal definition, but analysts and investors commonly consider two consecutive quarters of contracting gross domestic product to be a recession.
GDP gained 2.4% in the second quarter of 2023, and the Atlanta GDPNow model is currently projecting another 3.5% gain in GDP in the third quarter as well. By this common measure, there’s no recession in sight.
In the U.S., the National Bureau of Economic Research is tasked with officially calling U.S. recessions. The NBER’s definition of a recession is somewhat vague: “A significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
The Bureau of Economic Analysis will be releasing its revised estimate for second-quarter GDP on August 30.
As of this writing, U.S. companies are still hiring and consumers are still spending. In fact, the economy added 187,000 jobs in July. That type of job growth doesn’t typically coincide with a U.S. recession.
However, July job growth missed economist estimates of 200,000 new jobs, and job growth has slowed down significantly over the past year.
Why Are Investors Worried About a Recession?
The U.S. economic outlook has improved in recent months, but economists still see a difficult road ahead.
The Federal Open Markets Committee projected full-year 2023 GDP growth of just 1% back in June, suggesting economic growth could soon slow to a crawl. The Fed has also acknowledged the banking crisis in early 2023 tightened credit conditions, potentially making it more difficult for companies to secure loans.
The FOMC has made tremendous progress in bringing down inflation, but it remains well above the Fed’s 2% long-term goal. In fact, the June core personal consumption expenditures price index—which excludes volatile food and energy prices, and is the Fed’s preferred inflation measure—was up 4.1% on an annual basis.
Meanwhile, the Fed raised interest rates again in July, bringing the target fed funds rate range up to 5.25% to 5.5%. Interest rates are now at their highest level in 22 years—high interest rates weigh on both corporate earnings and economic growth.
S&P 500 companies are on track to report a 5.2% earnings decline for the second quarter, the largest decline in any quarter since the COVID-19 pandemic shutdowns in 2020. Energy sector earnings have been particularly weak, down 51.4% in the second quarter based on difficult year-over-year comparisons. Looking ahead to the third quarter, analysts are expecting just 0.2% earnings growth.
Rising credit card, mortgage, auto loan and other interest rates also reduce the amount of disposable income Americans have to spend in the economy, weighing on corporate earnings and stock prices.
Nigel Green, founder and CEO of deVere Group, says investors should be concerned about the potential delayed impact Fed rate hikes will have on the U.S. economy.
“The time lag for monetary policies is incredibly lengthy. It takes around 18 months for the full effect of rate hikes to make their way into the economy—and that’s where we are,” Green says.
The Case Against a Soft Landing
History seems to support the idea that a soft landing for the economy is very challenging to pull off. Since the 1950s, each period of U.S. disinflation driven by Fed policy tightening has coincided with a U.S. recession, according to Deutsche Bank.
One warning sign of a U.S. recession has been flashing for investors since mid-2022. The yield on the 2-year U.S. Treasury note is above the yield on the 10-year Treasury note, a phenomenon known as a yield curve inversion.
Inverted yield curves have historically been a strong economic recession indicator. Historically, two-thirds of the time the yield curve has inverted, the U.S. economy has fallen into a recession within 18 months. The last time the yield curve inverted was in late 2019, just a few months prior to the COVID-19 U.S. recession.
The yield curve is now well off its lows from early July, but it is still deeply in negative territory.
The Case for a Soft Landing
OWhile the potential for a recession is still concerning, the economy appears to be on solid footing for now.
The U.S. unemployment rate remains historically low at just 3.5%. The University of Michigan reported U.S. consumer sentiment was up 13% year-over-year in July to its highest level since 2021, suggesting shoppers won’t be slowing down anytime soon.
Not only has inflation steadily declined, it has come in below expectations in recent months. The consumer price index, a popular measure of inflation, was up just 0.2% on a monthly basis in July for the second consecutive month.
Charlie Ripley, senior investment strategist for Allianz Investment Management, says ongoing disinflation means the Fed may have already issued its final rate hike of the currency cycle.
“The soft landing narrative continued to build following the latest data on consumer prices,” Ripley says. “Overall, the case continues to build for the Fed to be done with the hiking cycle as real yields are well into positive territory and progress on bringing down inflation is evident.”
The bond market sees only a 30% chance the Fed will be forced to raise interest rates again this year, according to CME Group.
Throughout the first half of 2023, Bank of America economist Michael Gapen had been calling for a recession, but the latest batch of economic data changed his mind.
“We revise our outlook for the US economy in favor of a soft landing, where growth falls below trend in 2024 but remains positive throughout our forecast horizon,” Gapen says.
Bank of America is projecting full-year U.S. GDP growth of 2% in 2023 and just 0.7% in 2024.
“We still expect inflation to decelerate and remain on a path to 2.0%, but with a stronger forecast for activity and labor markets, inflation falls more gradually,” Gapen says.
Even Fed Chair Jerome Powell said in July that “there’s a pathway to a soft landing” for the economy. When asked about the economic outlook at the FOMC’s post-meeting press conference, Powell said Fed economists are “no longer forecasting a recession.”
What’s Next for the Recession Outlook?
Investors will be watching the upcoming Jackson Hole Economic Policy Symposium on Aug. 24-26 for additional commentary from Powell and other Fed officials about the U.S. economic outlook and the possibility for a soft landing.
In addition, investors should continue to monitor inflation data, consumer sentiment and the labor market. The University of Michigan releases its August consumer sentiment reading on Aug. 25, and the Bureau of Economic Analysis releases its July core PCE reading on Aug. 31. The Labor Department will also release its August U.S. jobs report on Sept. 1.
Should You Be Worried About a Recession?
If the U.S. does slip into a recession sometime in the second half of 2023 or early 2024, there’s no reason for investors to panic.
First off, historically recessions don’t last very long. The average duration of a U.S. recession since World War II is just 11.1 months. The Covid-19 recession in early 2020 lasted just two months.
U.S. recessions are fairly common. Since World War II, there has been about one U.S. recession every five years or so.
While recessions can lead to job losses and other financial difficulties for Americans, they have historically been excellent buying opportunities for long-term investors. It can be extremely difficult for investors to time a market bottom perfectly, but the S&P 500 has generated a 40% average return in the 12 months following its low point of a U.S. recession.
Some stocks even have a track record of performing relatively well during recessions. For example, Target (TGT), Walmart and Home Depot (HD) shares significantly outperformed the S&P 500 during both the 2020 and 2008 recessions.
READ MORE at Forbes.com
