The Possibility of Recession is Not Zero

Wall Street Economists' Views on Recession

Recently, there's been a growing belief among Wall Street economists that the risk of recession has drastically decreased. They predict that the economy will not even come close to a recession. Earlier this year, they predicted that the economy would grow less than 1% in each of the first three quarters. However, they now expect that the economy's growth will bottom out at an inflation-adjusted 1.4% in the third quarter.

This optimistic outlook seems to contradict several indicators that have historically signaled the onset of a recession, such as yield curve inversions. Currently, we are experiencing the longest consistent period in history where the yield spread between the 10-year Treasury bond and the 3-month Treasury bill is inverted. Yet, a recession has not occurred.

Historically Reliable Recession Indicators

Another historically reliable recession indicator is the 6-month rate of change of the Leading Economic Index. Just like the yield curve inversion, the current depth and duration of the LEI’s negative readings have always coincided with a recession. However, the U.S. has managed to avoid such an outcome this time.

Even the Federal Reserve’s tightening of monetary policy through one of its more aggressive rate-hiking campaigns did not push the economy into a recession. Given that the economy has continued to defy recession expectations, it is understandable that economists have stopped anticipating one.

The Risk of Recession is Not Zero

However, the question remains, has the risk of recession completely disappeared? The answer is no. While the risk may be low, it is not zero. One of the main reasons why the economy has managed to resist the recessionary drag from higher borrowing costs has been the ample supply of fiscal support. This support has come from previously passed spending bills like the Inflation Reduction Act and the CHIPs Act. Along with stimulus checks, tax credits, and moratoriums on various debt payments like rent and student loans, the amount of monetary support for consumption has supported economic growth.

It's crucial to understand that this surge in monetary support acted like an adrenaline boost to the economy. Many economic data series suggest the risk of recession is elevated. However, the surge of monetary injections sent the economy into overdrive, as evidenced by economic growth in 2021.

Recession Timing

The key point to understand is that the economy slows as the adrenaline boost fades. If the economy had been growing at 5% nominal, as in 2019, the decline from the post-pandemic peak would already register a recession. However, given that nominal growth neared 18%, it will take much longer than normal for growth to revert below zero. Based on historical analysis, we can estimate the reversion of economic growth into a recession could take roughly 22 quarters. This would time the next recession in late 2025 to mid-2026.

Investors Should Remain Cautious

For investors, while consensus estimates of economists put the risk of recession very low, it is not zero. Therefore, it is important to pay special attention to data historically correlated to economic growth.

Economic Data Indicators

For example, real retail sales have weakened significantly since the peak of economic activity in 2021. Retail sales make up roughly 40% of Personal Consumption Expenditures (PCE). Therefore, it is unsurprising that retail sales precede PCE changes. The importance of that lead is that PCE comprises nearly 70% of the GDP calculation. Therefore, as consumer demand slows, the economy slows, and inflation falls. Real retail sales are now negative as consumers run out of excess savings, likely slowing economic growth further in the quarters ahead.

Without employment, it is hard to increase economic consumption further. A key leading indicator to every previous recession has been a reversal of full-time employment. While it is certainly possible that the economy could avoid a recession given additional monetary or fiscal support, government and business investment comprise a much smaller contribution to GDP than consumer spending. With consumers strangled between declining wage growth and higher living costs, the ability to fuel the difference with debt is becoming increasingly challenging.

Conclusion

It is important to pay attention to the economic data in the future. While it may take much longer than many expect, the risk of recession is likely greater than zero. This article provides a fresh perspective on the risk of recession and the factors that influence it. What are your thoughts on this matter? Feel free to share this article with your friends and discuss it. Also, remember to sign up for the Daily Briefing which is everyday at 6pm.