Where did the recession go? Many pundits are looking at the continued strong economy and suggest that we may have avoided the contraction that follows the bursting of a bubble economy. Others are less sanguine. Who will be right?

The Economy

The bulk of the economy, represented by the services sector, continues to chug along, while the manufacturing element continues to pull back. The labor market continues to be tight, although there have been sporadic layoff announcements, and the unemployment rate ticked up to 3.8%. The GDP growth rate was a reasonably healthy 2.1% in the second quarter, and inflation has receded from recent highs of 8.9% down to 3.7%, although it is still too high for the Federal Reserve’s liking. Consumer sentiment is fairly normal, and spending continues at a good clip, although it is below the peak that was recorded in 2022. Spending on vacations has tripled from the level of the pandemic low.

The Markets

Because of the continued restrictive Federal Reserve policy, investment markets remain under some pressure. Long-term interest rates have reached 4.7%, a level that has not been seen since 2011.This rise has extended the bond bear market, reducing values to lows not seen since 2014. Bond losses have produced a drag on the returns of a typical balanced allocation portfolio and target date funds. Higher interest rates affect growth stocks more than others, so they have only partially recovered the drop from their late 2021 highs, while large value stocks have exceeded 2021 prices. Much of what stock market strength there is has been concentrated in the so-called “Magnificent 7”* stocks, which have recovered almost all of their prior losses, and in doing that have driven the capitalization-weighted S&P 500 index to an 11.6% gain this year. This contrasts with only a 1.6% gain for the average S&P500 stock and 2.5% return for smaller stocks.

Recession – MIA?

Over the centuries, many people, including author Mark Twain, physicist Niels Bohr, and baseball philosopher Yogi Berra, all came to the conclusion that "Predicting is difficult, especially about the future". It would seem that this is especially true in the realm of economics as well. During 2021, stock market followers suggested that the future would be wonderful and stock prices would advance forever. In 2022, opinions reversed and recession predictions were commonplace. In 2023 the recession worries faded into the background, and predictions of a soft-landing or no recession at all gained traction as we witnessed continuing economic growth and an Artificial Intelligence driven market rally. The fact that a recession has not occurred on the presumed schedule does not necessarily mean that the risk has evaporated however. It may just be a question of when. The gestation period between Federal Reserve action and occurrence may just be longer than our cultural short-term attention span.

Although predicting economic events usually produces questionable results, we can, however, study history to recognize what past economic forces have been present and observe the eventual outcomes, knowing that no two instances are ever the same. In the current case, several markers are similar to relatively extreme past situations.

1) The Conference Board’s index of leading economic indicators just declined for the 20th straight month and is 10.5% from its high. Since 1959, a recession has always followed a decline of this magnitude. Furthermore, there has only been one time when the index dropped for this many months in a row before a recession occurred. It was in 2008, preceding the "Great Financial Crisis”.

2) The unusual condition when short term interest rates are higher than long term rates is called an "inverted yield curve”. The yield curve has inverted six times since 1976. Each time was followed by a recession. Only twice, in the double-dip recession of 1980 and 1981, was the depth of the inversion greater than the recent level.

If a recession is in our future, why has it not shown up by this time? It is clear that the last decade was an unusual time in economic history as the Federal Reserve pursued its experimental Quantitative Easing policy for twelve years, and the government doubled down with pandemic "helicopter" cash payments. These factors inflated the "everything bubble" and sent stock prices higher to extreme long-term values. The bubble is slowly deflating, and valuations are somewhat lower, but the effects remain. The excess cash that saturated the economy from the government and Federal Reserve’s largess has been acting much like a savings account that is being slowly drawn down and delaying an eventual reckoning. After spiking in 2020, with the Federal helicopter money payments, consumer savings were reduced in 2022 and 2023 to a lower rate than it was before the pandemic, as many consumers are spending the available cash. The level of personal expenditures is still almost twice as high as pre-pandemic levels, but is well off the peak. Consumers and the services sectors of the economy are reasonably interest rate insensitive. These sectors have been able to continue to spend and grow while manufacturing and real estate, which are more sensitive to interest rates, have felt the major impact of the Fed rate policy.

In order to slow inflation, tightening credit will not do the job by itself. After intentionally bursting the bubble in early 2022, the Federal Reserve continues to pursue its objective of cooling down the economy by raising interest rates. They intend to keep rates "higher for longer" until the effects have had a chance to be felt in other areas of the economy. Services and workers will eventually be affected by scaling back consumer expectations and their ability to buy. This requires an economic slowdown and an increase in unemployment. Tight labor market conditions and the presence of inflation result in labor actions like the current UAW strike. If these conditions continue, inflation will become embedded in the economy as increased wages translate into increased prices. The Fed does not want to see this happen.

But Federal Reserve policy is said to be more like a hammer than a scalpel, and it takes time to work. Our economy is built on debt. Depending on the type of debt, the effect could be felt either sooner or later. If a consumer uses revolving credit card debt or needs a loan to buy a house, the effect of higher interest rates is immediate. On the other hand, for those who locked in a 30-year mortgage when rates were low, the increase will not be felt until it is time to move, and a new mortgage is acquired. The same is true for business financing. Bank loans may adjust at different times, and bonds may mature either sooner or later. As companies become exposed to higher credit costs, they will suffer profit declines, possibly prompting the lay-off of workers. Also, organizations in poor financial condition may go out of business. These effects take time, but if tight credit remains, they will happen eventually, slowing the economy until consumers and companies can make financial adjustments.

The conclusion is that, just because a recession has not happened does not mean that it will not happen if the Federal Reserve continues its policies. Because of the unprecedented amount of left-over embedded money in the economy, the glide path into recession may just be longer than usual. Because the lead time is longer, it is also possible that the eventual effect will continue to grow during an extended lag period and the result may be stronger than usual. Or maybe not. Perhaps the Fed will give up early and reduce rates again and we will experience a “stagflation" period like the 1970s. As they say, "Predicting is difficult".

Since predicting is both difficult and unreliable, what is a person to do? As always, our answer is to be aware of the economy and markets. Do not get married to the predictions of “experts” - or your own. Adapt. Have a financial approach and plan that can recognize and be adjusted to events as they occur.

 

*Nvidia (NVDA), Meta Platforms (META), Amazon.com (AMZN), Microsoft (MSFT), Apple (AAPL), Alphabet (GOOGL) and Tesla (TSLA)