In a recent November Monday Club, arranged by Global Growth Advisory Group LLC, a group of financial executives in New York discussed the likelihood of a U.S. economic recession.
Inflation is still at the highest rate in four decades and the Federal Reserve is unlikely to reverse policy course anytime soon. The market earlier believed that the Fed might pivot to a more moderate stance on interest rate hikes, but it seems clear that the Fed’s measures have not been enough and there will not be a pivot any time soon. The Fed has done a poor job predicting interest rate and inflation movements and an even worse job battling the inflation. They started with rate hikes far too late, and the hikes have been far too modest.
Inflation is a lagging indicator and does not unusually decline until unemployment rise and the economy enters a recession. The historic experience is that higher unemployment is necessary to reduce inflation. This makes it exceedingly difficult for the Fed to tighten just as much as needed to reduce inflation while at the same time avoid a recession. Given their recent track record, there are no indications that they have a solid plan, but rather go with the flow based on monthly economic reports and data.
There are several troubling indicators that the economy is heading towards troubled times, according to the Monday Club participants. A decline in industrial production and downward revisions to prior data suggest activity is losing steam. Manufacturing production eked out a modest 0.1% gain in the month of October. The continued rise of interest rates and growing uncertainty are notable headwinds to the sector. This is likely beginning to weigh more meaningfully on manufacturing activity. The new orders component has been in contraction territory in four of the past five months and suggests slower growth ahead. Small businesses plan to increase capital outlays have also rolled over. Increased concern over coming economic prospects and a higher rate environment are not favorable conditions for capital investment spending.
Weakness also extended to the housing market. Total housing starts fell another 4.2% in October, bringing the annualized level to 1.425 million units. The fall in housing starts continues to be concentrated in the single-family sector where starts fell to the lowest rate since May 2020. Forward-looking building permits suggest little relief is in sight, with single-family permits also dropping to the lowest level since the early months of the pandemic. Moreover, the Housing Market Index fell for the 11th straight month, dropping to its lowest level since April 2020. The current sales, future sales and traffic of prospective buyers’ components all decreased and are running at very lows levels. It was argued in the Monday Club discussion that it is a matter of a normalization phase for housing. It was frankly too easy to finance housing earlier with the interest rate close to zero and the government handing out free money. Housing can be said to be in a correction phase, but real estate is very much still a key component of an increasingly U.S. asset-based economy.
At the same time, some economic indicators are coming in slightly better than expected, supporting economic resilience of the economy and consumers. The stronger-than-expected performance makes the Fed’s job of taming inflation that much more difficult. The only solution is to keep increasing interest rates until inflation is back to a reasonable level and preferably on the target rate of 2%. The most current projection for Q4 U.S. real GDP growth at an annualized rate is 4.2%. This solid growth number certainly shows resilience, but it will make the pressure on dealing with the inflation even greater.
The Monday Club participants had a lengthy discussion about the role of the Federal Reserve bank and its failures and how this is impacting rates and yields. Various points of the treasury yield curve have inverted this year amid the Fed’s policy tightening cycle. The spread between the yield on the two-year Treasury and the 10-year Treasury notes first turned negative in the spring and has become even more inverted in recent months, recently reaching a new low of -68 bps. Earlier in the year, the Fed cited a different segment of the yield curve that focuses on shorter maturities as the best empirical yield curve measure for future economic performance. That metric, which was sharply positive earlier in the year, has steadily flattened this year and turned slightly negative in November. If yields on shorter-term securities are above those of longer-term securities, it suggests that markets anticipate that interest rates will start falling at some point down the road. At this point, all economic forecast is in line with a yield curve that is signaling turbulent times ahead.
The Monday Club participants believe that the Fed will keep hiking rates through mid-year 2023, followed by an extended pause that leaves the federal funds rate slightly above 5%. Once inflation has moved closer to 2%, one can expect rate cuts to come back into view. Accordingly, the yield curve will start steepening late in 2023.
While near-term resiliency in consumer spending and business investment look to support overall growth in the current quarter, economic momentum will slow going forward.
The Monday Club participants argue that the recession might be mild or even shallow, but with a higher unemployment rate, continued high inflation, continued high interest rates, strong dollar, and an ongoing and even increased political inefficiency, it is most likely that the U.S. economy will enter recession in the second half of 2023.