Fed Air: Prepare for landing

Online searches for the word "recession" are near what they were during the Great Recession, and economists, big banks, and news outlets are all fueling global fears by ringing the recession bell. Surging global inflation, hawkish central banks, supply chain struggles, a war between Ukraine and Russia, and China’s zero-COVID policy are just some of the many factors negatively affecting the global economic outlook, leading economists and institutions worldwide to lower their respective growth forecasts for 2022. The combination of these issues has significantly impacted investors, who were left with no place to hide this year except within the commodities space, as both equity and fixed income markets have experienced negative performance year-to-date. The biggest question mark among investors remains whether central banks will be able to achieve the famous "soft landing": slow economic growth enough to reduce inflation, but without tilting their economies into recession. However, this is by no stretch of the imagination an easy task to achieve, as there are a multitude of factors that are not within any central bank's control that could hinder efforts.

Engineering a soft landing

Since 1965, the U.S. Federal Reserve (Fed) has only been able to achieve a soft landing on three out of eleven occurrences: 1965, 1984, and 1994. However, it would be unfair to just blame the Fed for the subsequent recessions, as in most instances there were other factors that led to economic contractions. For example, the last two recessions followed hiking cycles. However, in the former, the Fed helped to burst the housing bubble, while the pandemic was the real culprit of the latter.

Bar chart of fed air GDP

Since they started to hike rates, the Fed has been successful in having an impact, with long-term interest rates rising significantly and mortgage rates skyrocketing. With a 75 basis point hike in June, the Fed changed its tone, taking a more assertive policy stance regarding its commitment to bring inflation down to the 2% target. Over the summer months, inflation is likely to roll over, but monetary policy from the Fed should remain on a tightening path for the rest of the year and into next year, if its current assessment of rates is not modified in coming FOMC meetings. While we don’t expect that the U.S. will enter a recession this year, it is important to consider what a potential recession could look like, if one were to occur. Tightening cycles have historically dampened economic growth, and consequently investment returns. However, it is important to remember that the economy and the stock market, while connected, are not the same thing. In fact, equity markets measured by the S&P 500 Index have had, on average, negative performance in the three months following the first Fed rate hike, but tend to have positive but relatively muted performance after that. Most importantly, the S&P 500 has been positive 71% of the time 12 months following the first Fed rate hike. On the other hand, average real gross domestic product (GDP) growth leading into the first Fed rate hike has been positive and growing up until the first rate hike (with some uncertainty leading up to it), and then steadily slowing down on average over the next 36 months. While a negative GDP reading is not ideal, it is important to note that historically it remains positive more than 85% of the time in the three years following the first rate hike.

Consumption is key

While all four components used to calculate GDP are important, consumption is by far the largest one of the four, accounting for approximately ~70% of GDP. So what drives consumer spending? Employment is arguably the biggest factor behind personal consumption. In fact, as people earn a steady stream of income, they tend to keep consuming. At the time of this writing, the unemployment rate stands at 3.6%, and there are over 11 million jobs available (almost one for every two unemployed people). Therefore, the labor market continues to be strong, and unless this changes significantly, it should not negatively impact spending. Another factor is consumer confidence, which indicates future expectations of the consumer; and, while it’s been on a downward trend, it’s still above its 30-year average. Lastly, interest rates and prices have a big impact on consumers. The first makes consumers choose between present and future consumption. That is, as interest rates increase, consumers tend to postpone current consumption for higher consumption in the future. However, since interest rate increases have not translated into much higher rates paid on savings, it is unlikely that consumers are going to postpone current consumption for future consumption. Meanwhile, higher prices reduce the purchasing power of incomes and thus puts downward pressure on consumption. However, the accumulation of savings during the pandemic seems to be keeping consumers in the consumption lane for the time being.

While consumption is the largest contributor to GDP, gross private domestic investments is the component that tends to be a harbinger of future economic growth. Recessions do not start with the consumer, but rather with a slowdown or a decline in private investments. When the economic outlook deteriorates, companies tend to decrease their investments to weather a potential storm. One of the first indications of a change of heart by firms comes as an increase in the accumulation of inventories. As inventories accumulate over atypical levels, they first start to adjust their purchase/production. Thereafter, they start to lay off workers, slow down or temporarily halt hiring, and stop or postpone the purchase of machinery and equipment, and so on to reduce spending.

The wealth effect misconception

Americans have seen their net worth surge significantly since the pandemic began, but the truth is, most people don’t live off their net worth. While experiencing an increase in net worth puts a consumer’s mind more at ease when purchasing big-ticket items, for most Americans, income from their jobs remains the most important factor. The good news is that across the various income quintiles, most incomes are higher than they were prior to the pandemic, and even more important, they increased more than what we estimate their expenses have increased. Additionally, more people have the ability to work remotely nowadays than they did back then, reducing or eliminating their commute to work and consequently reducing their gasoline expenditures.

The bottom line

Will there be a recession in the US and when will it be? We don’t know, but recessions have occurred many times in the past and will occur again in the future. However, if one were to come along in the near future, it is likely that it won’t be as strong as the Great Recession, but rather a mild economic slowdown due to the effects of tighter monetary policies. The U.S. economy is resilient, its job market is strong, and Americans are flush with cash ready to be deployed. However, business investments should be paid close attention to, as repeated changes in some of its components could signal troubles ahead.

You are now leaving LoftAdvisors.com

Any products and services accessed through this link are not provided, endorsed or guaranteed by Loft Advisors. You are advised that Loft Advisors' privacy policy does not apply to the linked website and you should consult the privacy disclosures on the third-party site for further information. To remain at our site, click 'Stay'. To go to the linked site selected, click 'Continue'.

Continue Stay