There’s a saying in markets that being early is being wrong. Given that maxim, it’s fair to say that over the past two years pessimistic economists and market analysts have been wrong.
Bearish forecasters began to warn of a recession and corresponding stock-market selloff as early as April 2022. Take, for example, an October 2022 Reuters poll in which 65% of the economists it surveyed said a recession would arrive in the following 12 months. Things were supposed 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 sliding, consumers are still spending, and the S&P 500 rallied as much as 20% this year before cooling off recently. And GDP is projected to grow by 1.6% in this third quarter, economists surveyed by the Philadelphia Fed said. Hardly recession material.
Optimistic, bullish economists are of course relishing the opportunity to say “I told you so,” as consensus starts to bend toward their view that the economy will achieve a soft landing — lower inflation without the need for an economic shock like a recession. Economists at Bank of America and JPMorgan now say a recession will not happen this year, or perhaps at all.
But just because the economy’s flight path seems gentle now doesn’t mean that there won’t be turbulence ahead. According to top Wall Street strategists and economists I’ve spoken with in recent weeks, there’s plenty of evidence that a recession is on the way. In other words, bulls are declaring victory far too early.
“To say today that we’re going to have a soft landing is so premature,” Michael Kantrowitz, the chief investment strategist at Piper Sandler, told me. “History tells you you really can’t make that assessment.”
Long and variable lags
The fulcrum on which much of the economy pivots is the Federal Reserve’s interest-rate policies. Higher interest rates for various types of loans — mortgages, auto loans, and credit cards — hamper people’s ability to afford purchases big and small, not to mention weigh on businesses’ ability to borrow. In theory, these higher interest rates push down demand and slow inflation by forcing companies to cut prices to attract stretched-thin customers. Lower interest rates work in the reverse, stimulating the economy by making it cheaper to borrow.
The Fed’s onslaught of interest-rate increases over the past 16 months — going from near zero to 5.5% — have been at the center of the “recession is coming” argument all along. The current hiking cycle is the fastest and most aggressive since the early 1980s, and this historic increase in the cost of borrowing was supposed to put the brakes on demand, slow consumer spending, hurt corporate earnings, and cost people jobs.
Instead of this hard reboot, however, the economy has been through more of a soft reset. Inflation as measured by the Consumer Price Index has fallen from its year-over-year peak of 9.1% in June 2022 to 3.2% as of July. And Americans have been spending right through the higher interest rates: Personal consumption expenditures and retail sales numbers have continued to forge upward.
Sure, the economy has seemed to shake off the Fed so far, but experts say that higher cost of debt will eventually bite. As the legendary economist Milton Friedman famously said interest rate changes have “long and variable lags” — it takes time for the changes to work their way to households and businesses. Bob Doll, the chief investment officer at Crossmark Global Investments and a former chief US equity strategist at BlackRock, told me that the full impact has yet to be felt.
“To think that the only consequence is that a couple banks go under in the middle of March for about a day and a half, and then we move on our merry way, 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 the founder of Rosenberg Research, was one of the first to sense the cataclysm that turned into the 2008 recession. He’s been calling for a recession since last year and told me that despite the more upbeat recent data, a downturn is still on the way. Rosenberg noted that the average time from the Fed’s first interest-rate hike in a cycle to the start of a recession is about 15 months — and the current hiking cycle has been going for 16. But as was the case in the 2008 recession, things look like they’re playing out over a bit longer timeline in this cycle. When the economy dipped into recession in December 2007, it had been 3 ½ years since the Fed started to raise rates in July 2004.
Rosenberg thinks the longer lag this time around is due to fiscal stimulus that was sent out during the height of the COVID-19 pandemic. The amount of cushion the stimulus checks and other aid provided means that people can stomach higher interest rates for a while and consumers can adopt a more “YOLO” (you only live once) attitude about spending. But eventually, this attitude will wane as people realize that the higher rates aren’t 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 delinquent, up from just over 4% in 2021. In the aftermath of the Great Recession, that number reached as high as about 14%. Auto loan and mortgage delinquencies are also rising.
For others, the lagged effect of inflation itself will weigh on consumers and help tip the economy into recession. Tom Essaye, the founder of Sevens Report Research, which counts some of the biggest institutions on Wall Street among its clients, said while inflation on a year-over-year basis has come down significantly, the cumulative price increases we’ve seen since the start of the pandemic will eventually force consumers to cut back on spending.
“People get very excited about CPI and say, ‘Hey, CPI went up only 0.1% over the past month and it’s only up 3% over the past year,'” Essaye said. “Well, think about that in practical terms. If I go to buy my kids a bag of Skittles, in 2019 it cost $0.75. Now it costs $1.50. Am I supposed to get excited because next year it costs $1.55?”
The wheels of industry slow
Piper Sandler’s Kantrowitz pointed to another worry spot: manufacturing. Industrial production, a measure of just how much stuff is coming out of US factories, is starting to trend downward. And surveys of manufacturing executives, like the Institute for Supply Management’s Purchasing Managers Index, show that there’s widespread worry across the industry. Even as the sector has taken a hit, rate hikes are still working their way into manufacturing data. A Granger causality test, which establishes the highest point of correlation between two datasets, showed that it usually takes about 18 months for rate hikes to fully show up in manufacturing data. That means more downside is likely ahead. While manufacturing is just one portion of the US economy, experts say that it’s important to watch because it’s a reflection of consumer demand, and therefore, a thermometer for the broader economy.
Another lagged effect of the rate hikes is the impact of tighter lending standards: Even if consumers and businesses are interested in taking out loans, banks have to be willing to give them. According to the Fed’s Senior Loan Officer Opinion Survey, more than half of banks are tightening lending standards for businesses, and that’s showing up in the supply of commercial and industrial loans, which have been falling since December. When this happens, it can mean banks are getting more worried about borrowers’ ability to pay back the loans amid economic uncertainty. Businesses use these loans to grow and to pay employees, meaning a drop in loan issuances weighs on employment and business growth.
But Kantrowitz and Rosenberg aren’t the only ones that think policy lags are still playing out. Rosenberg pointed to statements from the Fed chair Jerome Powell at a July press conference: “We have 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 hiked interest rates and not caused a recession. But these instances have been anomalous — 80% of Fed hiking cycles since World War II have resulted in a recession. Hardly an encouraging track record.
There is a key differentiating factor, Rosenberg said, that will indicate whether the economy is on the path to a true soft landing or will end up in a recession: the interest rates on different kinds of Treasurys. The Treasury yield curve measures the different interest rates that are paid out on various bonds issued by the US government. Usually, the interest rate on short-dated Treasuries — bonds that pay investors in less than a year — are lower than yields on far-out bonds like the 10-year Treasury. But when that flips and interest rates on short-term Treasurys are higher than their long-term cousins — known as a yield-curve inversion — is a sure sign of a recession, Rosenberg said. That’s because it’s a sign that investors are worried about the economy’s stability over the next few months and are seeking safety in long-term bonds. The yield and curve has been inverted since the end of last year. Since the 1960s, the indicator has a perfect track record of preceding recessions.
If a recession does come, investors are likely in for a tough period ahead. 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 are expecting continued growth ahead. Kantrowitz pointed out that this year’s rally is one of the sharpest over the past 25 years, but it’s detached from fundamentals. For example, the market is soaring despite forward-earnings expectations being negative and manufacturing remaining in contraction territory. It’s the same story every time, both Kantrowitz and Rosenberg say: Investors are bad at pricing in a recession before it unfolds.
How much stocks fall in a recessionary scenario probably depends on the depth of the downturn. Doll, for instance, only sees a mild recession ahead, and therefore sees the S&P 500 likely falling as much as another 13%. But in the past 13 recessions, the S&P 500 has dropped an average of 32%, as the Royal Bank of Canada noted.
Based on the current strength of the market, a recent summer swoon notwithstanding, most investors assume that the optimists are right: Inflation is going to stay low, the labor market will hold up, and the effects of the interest-rate hikes are in the rearview mirror. But when markets get complacent, Kantrowitz said, “historically, people have gotten in trouble every single time.”
William Edwards is a senior investing reporter at Insider covering the US stock market and the economy.
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