A US Recession Is Coming (But Not This Year)

Summary

• With the Fed hiking aggressively and GDP growth slowing, calls for an imminent US recession dominate headlines.
• But we think a Fed-induced recession is more likely in 2023, not 2022.
• US GDP growth is slowing partly because it is returning to trend and partly because it is experiencing a temporary soft patch.
• Labour market strength and falling savings will keep the economy from sliding into recession. But inflation will keep climbing as the wage-price spiral strengthens.

Market Implications

• The Fed will likely keep hiking through 2023 as prices continue to rise.
• The market is underestimating the extent of Fed tightening, and bonds and stocks have further downside.

Recent Soft Data Is Misleading

A string of negative data surprises has markets pricing cuts to the Fed’s main interest rate for 2023. The rationale is that a recession is imminent and likely to return inflation to 2% with less Fed tightening than previously expected.

I disagree. Certainly, the economy is slowing. It is returning to trend following extreme, pandemic-related volatility. It is also experiencing an air pocket. But it is not headed for an immediate recession. Rather, I expect a Fed-induced recession in 2023, and here is why.

The US Economy Is Returning to Trend

Recent data indicates a slowdown in growth. Yet we should expect this because the US economy is returning to trend following the pandemic-induced volatility (Chart 1). True, Q1 2022 GDP growth was -1.6% qoq saar. But once you remove volatile components (inventories, net exports and government), growth was 3% qoq saar.

A Temporary Soft Patch for the US Economy

That said, the current slowdown is more than a simple return to trend. I think the economy is hitting an air pocket for three reasons: inventory cycle, dollar strength and peak fiscal consolidation.

Decreasing Inventories Reflect Normalization, Not a Recession Signal

A key source of market concern has been inventories. In Q1 2022, the contribution of inventories to growth was -0.4%. The Atlanta Fed’s latest GDP “nowcast”  sees the contribution of inventories to GDP growth in Q2 at -2.4%. Media reports of inventories overhang at large retailers echo this macro data.

In my view, the ongoing decrease in inventories does not signal an impending recession for three reasons:

• It follows two quarters of strong increases.

• The inventories to sales ratios (census data) at the retail, wholesale and manufacturing levels remain below pre-pandemic levels.

• The decrease in inventories is happening against a backdrop of overall strong consumption growth and reflects a switch from goods, especially nondurable goods consumption, to services rather than broad-based demand weaknesses.

Because the inventory cycle reflects normalization rather than unexpected, broad-based demand weaknesses, I expect it to be over by end-year.

Strong Dollar Lowering US Growth – and Inflation

In addition to the inventory cycle, dollar appreciation is also contributing to softer growth.  On a real, trade-weighted basis, the dollar has appreciated 12% over the past 18 months (Chart 2).

According to the Fed models, a 10% dollar appreciation lowers GDP by about 1.5% after three years, with over half the impact occurring after a year. The data seems roughly in line with this view: over the year to Q1 2022, net exports subtracted 1.7 ppt from growth (GDP growth was 3.7%), and the impact was particularly severe in Q1.

A stronger dollar also lowers inflation. The Fed models estimate that a 10% dollar appreciation lowers core PCE by about 0.5% in the two quarters following the appreciation, and gradually reverts it to base line.

Our dollar view is bullish over the medium term but bearish longer term. This suggests the dollar’s negative impact on growth and inflation could peak in Q4.

Peaking Fiscal Consolidation

The third factor hitting growth is fiscal consolidation. Take the Hutchins Center Fiscal Impact Measure. It estimates how much local and federal government taxes, transfers and spending add or subtract to GDP growth. And it shows peak negative impact of fiscal policy in Q2 2022 (Chart 3).

Strong Employment Growth and Dissavings Will Prevent a 2022 Recession

The above discussion suggests growth is likely to remain soft in Q2-Q3. But I do not expect this soft patch to turn into a recession for two reasons.

First is labour market strength. Employment growth is currently about 4.5% on an annual basis. Employment growth has never been this strong at the start of a recession.

Second, the household savings rate will likely continue to fall as households spend the savings accumulated from pandemic-related transfers. After all, unemployment and the need for precautionary savings are low. Median household wealth remains high despite the selloff. And retail savers’ real interest rates are negative.

Continued Expansion to See Stronger Wage-Price Spiral

As inflation rises, it has broadened into wage growth (now at 6.1%). And the wage-price spiral will probably strengthen as the expansion continues. This is because, with unemployment back to decades low and demand still strong, employers are bound to pay up to secure additional workers.

Already, anecdotal evidence tells of employers accelerating wage increases to secure their workforce. In addition, the ongoing consumption switch from goods to services is bound to increase the demand for workers in the services sector, and therefore wages.

In its latest annual report, the BIS highlighted that economies currently face significant risks from moving to a high inflation regime due to the development of wage-price spirals. It further stressed that withdrawing from a high inflation regime entailed large output and employment costs.

Market Consequences

Together with the above discussion, the BIS report adds to my conviction that the Fed will have to keep hiking interest rates into 2023 and much higher than the market currently expects – even approaching 8%.

If my view is correct, the Fed is mispriced, and bonds and equities have further downside.