A Bumpy Road Leading to Recession

Over the past few months, we have referenced the Dave Matthews Band’s song “The Space Between” to describe the current economic and market environment. Simply put, we have believed that investors were in the process of shifting from fears about inflation, which have driven markets for much of the past year, to fears about a recession. The first quarter of 2023 saw markets swing rapidly between those two end posts.  

The last few months of 2022 were marked by weak economic data coupled with disinflationary trends. However, the narrative quickly shifted at the beginning of 2023 as stronger economic data reignited fears that inflation would remain elevated. Then, in the second half of the first quarter, the narrative shifted sharply as stress in the banking system led to the failure of Silicon Valley and Signature banks as well as the arranged sale of Credit Suisse to UBS Group in mid-March. While we don’t believe these events are a precursor to a cascading wave of bank failures like what the markets endured in 2007–2009 during the Great Financial Crisis, we do believe they are signs that the Federal Reserve’s ultra-aggressive rate hike campaign over the past year is beginning to exert a greater impact on the U.S. economy. When liquidity begins to dry up, cracks are first revealed in places where there were excesses in the past. Simply put, these were prime examples of concentrated client bases, asset liability mismanagement and poor overall risk control. 

With inflation in the rearview mirror, the Fed should have room to ease interest rates if needed to help stem the depth of any economic decline.

Consistent with our outlook, investors ended the quarter pushing through the “space between” toward recession fears. While equity markets managed to eke out positive returns, they finished off their highs registered during a strong start to 2023. Importantly, after rising in the beginning of the year, fixed income yields pushed sharply lower as recession fears grew along with expectations that the Federal Reserve would likely pause rate hikes and ultimately cut rates later in the year. It’s important to note that after a disappointing 2022, when high-quality bonds did not hedge equity market downside, fixed income once again returned to its traditional role as a hedge or a ballast to equity market underperformance.  

We continue to believe that a mild recession is on the horizon and that volatility will likely remain elevated as an economic contraction plays out. However, we reiterate our belief that any such recession will be mild and, importantly, will also serve as the final nail in the inflationary coffin. With inflation in the rearview mirror, the Fed should have room to ease interest rates if needed to help stem the depth of any economic decline. Importantly, equity markets have spent the past 15 months repricing in response to the potential for a recession, and high-quality bonds offer yields around 4.5 percent and once again provide the opportunity for real returns and play a powerful role in overall portfolio construction. We urge investors to stay the course and believe better days lie ahead.  

Economic back and forth but trending lower  

Despite the back and forth of the inflation vs. recession narrative over the past months, we continue to believe the trend remains in one direction — toward a Fed-induced recession that marks the end of heightened inflation. It is true that we have had spurts of strong “individual” economic data points as well as rotating hot spots in the inflation narrative, but things continue to move along through the business cycle, and taken in totality, both the economic and inflation data continue to point lower.  

In the Q1 2021 quarterly market we discussed our belief that the descent from the ultra-accommodative monetary and fiscal policy that occurred during COVID would cause volatility along the way. Much as descending from the summit of a mountain can be as dangerous as the ascent (or more so), so too was the economic experience as we came down from the peak of monetary and fiscal policy largesse that was brought about during the peak of COVID uncertainty. Certainly, the past 15 months have proven our expectations valid. Fortunately, while the descent from a peak can be nerve-wracking, the good news is that it eventually leads to solid ground on which to begin the next climb; so too will the sting from the aggressive pullback in monetary and fiscal policy.  

We believe we have arrived at the end of the Fed rate hike cycle. The liquidity tourniquet the policymakers have placed on the economy over the past year is now beginning to take maximum effect. Fed rate hikes coupled with quantitative tightening have packed a heavy punch while fiscal policy has waned, and more recently, banks have started severely tightening lending standards. During the first quarter, the Federal Reserve’s Senior Lending survey showed bank lending standards tightening to levels that have been consistent with past recessions. It’s worth noting that this survey occurred before the most recent bank stresses, which will likely lead banks to further tighten lending standards. The overall result has been the U.S. money supply contracting at a -2.4 percent year-over-year pace after rising by a record 26.9 percent year over year in February 2021 — think of this as descending the easy fiscal/monetary policy summit.  

Draining liquidity helped cool economic growth, with the majority of pain felt in interest rate-sensitive areas, such as housing as well as those segments of the economy that recovered first from the impacts of COVID (think goods). Recent surveys of manufacturers are already at levels consistent with recessions. While readings on the services side of the economy have remained relatively robust, we believe these will also begin to labor under the impact of rate hikes, a faltering economy and consumers and businesses tightening their spending habits in the coming months. Overall, leading economic indicators remain at levels that have preceded or been concurrent with recessions in the past 63-plus years. While this time could be different given the oddity of the COVID-influenced economy over the past three years, we continue to believe that the overall economy will slip into a recession as we progress through 2023. 

Inflation is following a similar track  

Inflation is also falling, albeit with much more noise clouding the trend. Over the recent past, much of the narrative was focused on areas where inflation is hot while selectively ignoring where it was not. The reality, we believe, is that more is falling into the “what is not” category, with formerly hot inflation readings following the trajectory of economic growth that first accelerated and then faltered. As such, we expect a similar outcome with more and more inflation data showing significant cooling.  

Recall that at the end of 2021, the markets and media were focused on supply chain snarls and port backups that led to high goods prices during a time of surging demand. Those days are over. A measure of global supply chain pressures developed by the New York Federal Reserve hit a record 4.3 standard deviations above the mean in December of 2021. During the first quarter of this year the measure fell to -0.26, showing that supply chain bottlenecks are no longer an issue. Similarly, U.S. ports have cleared, and shipping costs have faltered from above $10,000 per 40-foot dry container (the standard measure of container pricing) at year-end 2021 to nearer to the longer-term average of $1,700 as the quarter drew to a close. The overall result has been a sharp drop in goods inflation, from 12.3 percent year over year as of Feb. 2022 all the way down to today’s Feb. 2023 level of a meager 1.0 percent year over year. 

Rather than focus on these two areas of falling inflation, the conversation has moved to service sector inflation, as that part of the economy has experienced growth and recovery as Americans have returned to spending on activities and travel.

As supply chain snarls began to alleviate, the focus shifted in the first half of 2022 to commodity prices after Russia invaded the Ukraine and sent overall spot commodity prices (agriculture, energy and metal prices) up 36 percent through mid-June of last year. However, since then, commodity prices have fallen by 26 percent and now reside at levels  similar to what they were to start 2022.  

Rather than focus on these two areas of falling inflation, the conversation has moved to service sector inflation, as that part of the economy has experienced growth and recovery as Americans have returned to spending on activities and travel. But much as the other components of inflation have done, we expect service sector price pressures to buckle in the coming months as spending slows. Importantly, as we’ve noted in the past, much of service sector inflation comprises home prices and rents that come into the inflation calculation with a lag of 12 to 16 months. While home prices and rents saw strong increases in late 2021 and early 2022, we know that housing prices of late have been falling; we expect the decline to continue, which will put downward pressure on overall services inflation readings.  

Tying this all together, if you remove the lagging shelter component and look at those segments that are more current measures (goods/most services and commodities), inflation has been up 0.72 percent over the past eight months, or 1.08 percent annualized. In addition to our belief that economics will dictate continued falling inflation, simple math should also act as a tailwind for the disinflationary trend in the second quarter. Higher inflation readings occurred during the period between March and June of 2022 with extremely elevated month-over-month (non-seasonally adjusted) readings of 1.3, 0.6 ,1.1 and 1.4 percent, respectively. Contemplate that as we push through the second quarter, those numbers will come out of the year-over-year calculations. This means that if overall inflation runs 0.3 percent over the next four months, by June we will have overall CPI inflation checking in at 2.8 percent on a year-over-year basis.    

The bottom line: We believe inflation is set to continue moving lower.  

Why does the Fed keep tightening?  

The Fed’s worries go beyond current measures of inflation, as it is firmly focused on the labor market. The Fed worries about a repeat of the wage-price spiral that occurred during the 1966–1982 time period, in which wages consistently rose even against a backdrop of uneven economic performance, leading to persistently “sticky” inflation. In every economic cycle since 1982, the Fed has focused on wages and has aggressively raised rates when the labor market tightened. The gauge the Fed uses to discern whether the labor market is tight is wages. Over the last 41 years, the Fed has consistently tried to cap wage growth at 4 percent. Think about 2 percent for productivity and 2 percent for inflation. Wage increases above that level are viewed as likely stoking inflation pressures due to the reality of productivity constraints.  

We believe the only way a soft landing is possible is if workers return to the labor market and create additional supply that meets demand and caps wage growth.

The good news is that over the past few months wages have been moderating even as the unemployment rate has remained near historic lows. However, one would expect that relationship would revert to a more historical norm with wages rising if the labor market remains strong. This is where the recession rubber meets the road. We believe the only way a soft landing is possible is if workers return to the labor market and create additional supply that meets demand and caps wage growth. While there has been some positive movement in that direction, we believe it is unlikely to occur on a meaningful scale; as a result, the Fed is likely to err on the side of caution and try to produce labor slack by further slowing the economy. The unfortunate result of this approach is likely to be higher unemployment. Indeed, the reality is the Fed’s own internal forecast shows a recession as reflected by its forecasts of the unemployment rate rising to 4.5 percent by year end — a 1.1% change from its recent 3.4% low — which we would normally refer to as a recession.  

The silver lining  

While the picture we are painting sounds dire, the silver lining is that we believe any such recession will be mild for three primary reasons.  

1. We have already let steam out of various parts of the economy over the past year. Contemplate the concept of rolling recession as we move further from COVID.  

2. U.S. consumers have rebuilt their balance sheets over the past 14 years. Current U.S. consumer debt to net worth is at 13 percent as of the end of 2022 compared to 20 percent prior to the deep recession of 2007–2009. We also note that the banking system, despite the stresses of the past month, is in better shape than during the GFC.  The recent stresses occurred because of rising rates causing losses in high-quality bank assets. Contemplate that, over the past few weeks, U.S. interest rates have sharply declined, and those losses have likely shrunk.   
3. The Fed will have room to cut rates later in the year, which will keep any potential downturn from becoming deeper. Inflation expectations are well maintained, and wage expectations are low. This has little to no resemblance to the wage-price spiral of the 1970s and early 1980s.  

When will we know it’s a recession?  

From a market perspective, we continue to note that some of the likelihood of an economic downturn has already been discounted. If a recession started at the end of Q1, we note that the market today is already down 14.3 percent from its Jan. 3, 2022, peak, which would translate to the second largest drawdown of the last 11 recessions from prior peak to recession start date. We further note that this peak occurred 15 months ago, which places it as the longest time from market peak to recession start date. We also note that these observations are based upon the S&P 500 and that other parts of the market have been hit much harder over the past 15 months. Think about this as a sign that this likely recession has been well telegraphed.   

It is also interesting to consider that the market typically bottoms before a

recession ends. Indeed, in five of the past 11 recessions the market produced positive returns during the recession. It is also important to note that it is not always perfectly evident when the economy is in recession. Given the rolling nature of the current economic slowdown, it may not be evident that we were in the midst of a recession until well after the fact. This brings us to the topic of when we will know if it’s a recession. While we believe that the answer to the question lies with the labor market, a look back at other data provides a thought-provoking exercise, especially given the oddity of this cycle’s post-COVID-19 recovery.  

A look back at the 2007–2009 recession  

Before we delve into the data, let us again reiterate that we do not believe this recession will resemble the 2007 recession, as the economy is in a much different place than it was back then. However, we believe revisiting the GFC provides some food for thought for those who think they know when a recession is underway. For context, on November 28, 2008, the National Bureau of Economic Research determined that a recession began one year prior, on December 1, 2007.  

• Real Gross Domestic Product (GDP): Overall economic growth in the fourth quarter of 2007 checked in at 2.5 percent on a seasonally adjusted annualized rate and had been relatively strong during the prior quarter of 2007. During the first quarter of 2008, economic growth did fall into contractionary territory, falling by 1.6 percent, but rebounded to a positive 2.3 percent in the second quarter before dropping again in the third quarter of the year.  
   
  Current expectations are that first-quarter 2023 U.S. economic growth will come in at 1.3 percent, which will follow gains of 2.6 percent in the fourth quarter of 2022 and 3.2 percent in the third quarter. However, recall that we did have two consecutive quarters of negative growth to start 2022 (-0.6 percent in Q2 2022 and -1.6 percent in Q1 2022). As a reminder, two consecutive quarters of negative growth has typically served as the technical definition of a recession. 
   

• Retail Sales (U.S. Consumers): Retail sales in November 2007 were up 5.5 percent year over year, and while we did have a few negative months in December of 2007 and then again in February of 2008, sales didn’t turn solidly negative until July 2008 and beyond.  
   
  Retail sales as of February 2023 were up 5.4 percent, and over the past few months, we have had some large negatives as well as offsetting positives. Indeed, during the last six months of 2022, four of the six monthly readings were negative.  
   

• Industrial Production (U.S. Manufacturing): In November 2007, industrial production was up 3.25 percent year over year but began a steady decline into negative territory from that point forward before finally turning negative on a year-over-year basis in April 2008.  
   
  As of February 2023, Industrial production is up a meager 0.32 percent year over year, and four of the past five monthly readings have been negative.  
    

• Initial and Continuing Jobless Claims: This is where everyone is currently focused because the labor market appears to be the last shoe to drop before it is acknowledged that we are actually in a recession. Quite frankly, the labor market has appeared to remain strong, and everyone is poring over this data set for the hints of weakness. Prior to the GFC, the four-week average of initial jobless claims hit its cycle low at 287,000 in February 2006 and then remained around 320,000 until the beginning of October 2007 when it checked in at 312,000. It rose slightly to 340,000 on Nov. 30, 2007.  
   
  The latest cycle has been interesting in that this metric hit its cycle low of 171,000 on April 1, 2022. By August 5, 2022, it had spiked to nearly 250,000. It then took the elevator back down to 207,000 toward the end of September 2022 and rose back to 230,000 by early December. Since that date, the figure dropped to 189,000 by February 3, 2023, and over the past few weeks has climbed back to 198,000. While all these numbers are still low, we note the extreme volatility over the past year and rolling nature of the data. Continuing claims during this time have risen much as they did during 2007. Back then they bottomed in late April 2006 at 2.357 million and by the time the recession began had risen by 403,000. Contemplate that during this cycle continuous claims hit a bottom of 1.306 million in May 2022 and have now risen by 383,000 to 1.689 million at quarter end.  
   

• Conference Board U.S. Leading Economic Indicators: The six-month annualized pace for the Conference Board’s 10 leading economic indicators has been pointing to a coming recession for months and currently resides at -7.1 percent after hitting the lows of this cycle back in October 2022 at -7.4 percent.  
   
  In November 2007, this measure registered at -6.0 percent, a level we have been above during this cycle since September 2022.  
   

• The Equity Market: Lastly, we tie this all together with our earlier comments on markets peaking before recessions. The equity markets prior to the recession of 2007–2009 peaked on Oct. 9, 2007, a mere two months before the recession’s start date.  
   
  As we mentioned prior, we are now 15 months removed from the equity market peak that occurred in January 2022.  

While no two recessions are ever the same, and each has its own unique circumstances, we go through this exercise to drive home our point that it is not always evident when a recession starts; certainly, some data beyond the labor market has shown weakness since the beginning of mid-summer 2022. However, contemplate the oddity of the economy since the post-COVID recovery has occurred. The reality is trying to accurately time the declaration of a recession is going to be a tough task.  

The bottom line  

Discussions of a potential recession often leads investors to think they need to do something. A common refrain that we often hear is that given the level of uncertainty, why shouldn’t investors just go to cash and wait it out? We answer that in two ways. First, we recognize there are degrees of certainty (think confidence), but we are not yet in a time of absolute certainty. As such, if you invested only during periods of absolute certainty, you would risk missing out on substantial returns. Second, concentrating in one asset class suggests investors are absolutely certain of what is coming next for the economy and markets. 

We believe the best manner to deal with that volatility is through diversification, which acknowledges that no one knows for certain what will happen.

Tying this together is the reality that we are now three years past what one could classify as one of the most uncertain time periods in recent history. Markets took a harrowing ride in the first quarter of 2020, when stocks fell 34 percent in a mere 16 trading days in response to the arrival of COVID-19. Consider the missed returns an investor who exited the market at that time (because of uncertainty) would have experienced. Additionally, imagine the challenge an investor would have faced in trying to find the right time to re-enter the market after having gone to cash. Would they have waited for a more certain time to do so – perhaps, say, toward the end of 2022 after the market had risen to new highs? Only then they would have experienced the more than 14 percent drop as we moved back toward “uncertain” times. We would suggest investors concerned about the current uncertainty consider that from March 31, 2020, until today, the S&P 500 is up an average 18.6 percent per year over the past three years. Even if an investor was in the market on February 19, 2020, which was the start of the COVID plunge, the annualized return as of the end of the first quarter of 2023 is 8.14 percent.  

The way we suggest dealing with uncertainty is 1) develop a financial plan, and 2) always adhere to diversification. Work with your advisor to develop a financial plan that you follow through both good times and bad. Embedded within that plan is the reality that life and markets are uncertain. Any resulting asset allocation acknowledges that potential volatility. We believe the best manner to deal with that volatility is through diversification, which acknowledges that no one knows for certain what will happen. At Northwestern Mutual our advisors have tools to help prepare for all of life’s unfortunate events and uncertainties.   

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.  

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.  

Follow Brent Schutte on Twitter and LinkedIn.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.  

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.