recessionary outlook:assessing the likelihood

June 23, 2023

While the Federal Reserve Board (Fed) chose to skip another rate hike at its June meeting, it signaled that it may increase rates later in 2023. Its June decision came after 10 consecutive rate hikes starting March 2022, with the upper bound of its target rate now 5.25%. This hiatus should be of relief to consumers who are seeking mortgages or car loans or are paying credit card bills.

However, half of the Fed’s voting members projected that the target rate will rise to 5.75% by December. Thus, the Fed’s rapid—and potentially continued—rate increases have raised the threat of a Fed-induced recession within a year.

In this report, The Mather Group, LLC (TMG) shares its outlook for a potential recession, major factors that could cause it, and links among those factors. Recessions often need a chain of adverse events to occur—not just one, such as Fed tightening.

Other factors that could contribute to a recession are changes in bank credit, consumer spending, consumer confidence, unemployment, wage gains, and stock market performance. Economic shocks such as wars, oil embargoes, and global pandemics are unforecastable, and so are not included in this report.

Fed Interest Rate Policy

The historic link between Fed interest rate increases and potential recessions is evidenced through a credit market event known as “yield curve inversion.” Normally, due to increased financial risk when funds are invested for extended periods, investors demand a higher return. So, the yield curve going from short-term (91-day Treasury bills) to longer-term (30-year Treasury bonds) assets is usually upward sloping. However, when investors believe that a recession may be on the horizon, the yield for short-term assets begins to rise above longer-term yields. This is described as a yield curve inversion, as the yield curve now slopes downward.

Why would an inversion suggest a looming recession? As shown in the graphic below, each time the yield curve has inverted since 1989 due to Fed rate hikes, a recession has resulted. Inversion occurs when the yield difference drops below 0.0%, with recessions shown as gray bars. With a current value of -1.75%, the inverted yield curve is now at its lowest rate in the last 34 years.

So, this interest rate factor suggests that a recession may occur.

Bank Credit

As shown in the graphic below, a decline in the growth of commercial bank credit during the last 34 years often preceded a recession. An explanation is that when the Fed raises rates, the demand for credit falls due to tighter bank lending standards and increased caution among businesses seeking loans. At the outset of 2022, bank lending grew at an annual rate of 10%, but with Fed tightening beginning March 2022, its annual growth rate has declined rapidly to just 2%.

So, this bank credit factor also suggests that a recession may occur.

Consumer Spending

Personal consumption represents about 70% of our gross domestic product (GDP). As shown in the graphic below, the pandemic introduced enormous volatility in the annual growth rate of consumer spending. Prior to the pandemic, in February 2020, the annual growth rate was 4.8%. It rose to 30.0% in April 2021 due to pandemic stimulus programs, but because these programs have ended, the annual rate has descended for two years toward its current level of 6.7%.

One reason for this decline, according to Bureau of Economic Analysis (BEA) studies, is that consumers accumulated $2.1 trillion of “excess” savings due to pandemic stimulus payments. The BEA estimates that only $600 billion of these savings remain, so, when combined with continuing inflationary pressures, the annual spending rate could decline further to more historic levels.

So, this consumer spending factor suggests that a recession may not occur.

Consumer Confidence

Of course, consumer spending is linked strongly to consumer confidence. In turn, confidence is driven by multiple forces and is often volatile. Prior to the pandemic, confidence remained relatively level, but then dropped precipitously with the pandemic’s arrival. It then rose with the inflow of pandemic stimulus funds but dropped to its recent low of 50.6 in June 2022. It then rose steadily for 12 months to a level of 63.9 in June 2023.

So, this consumer confidence factor also suggests that a recession may not occur.

Unemployment Rate and Wage Gains

If consumer sentiment helps drive consumer spending, so does being employed and receiving salary increases. As shown in the graphic below, both factors suggest increased labor force resiliency as the pandemic subsided. After reaching an unemployment rate of 14.7% in April 2020, the level has declined significantly to 3.7% in April 2023.

This level is concerning to the Fed, which believes the non-accelerating inflation rate of unemployment (NAIRU) should range between 4.5% - 5.5%. Unemployment rates below the NAIRU are deemed to be inflationary and to restrict GDP growth due to worker shortages.

As expected, the recent worker shortage has resulted in a significant increase in the annualized Employment Cost Index (ECI), which combines wages, salaries, and benefits. Prior to the pandemic, the ECI ranged from 2.5% - 3.0%. Starting in Q2 2021, however, it began to rise above this range and reached an annualized rate of 4.9%.

In several prior inflationary periods, a “wage-price spiral” occurred, with workers demanding higher pay levels to offset rising inflation. Employers then offset these higher pay levels with price increases, which then spurred workers to demand even higher pay levels. The fear of such a spiral occurring now has led the Fed to suggest the need for even higher interest rates in the near term.

So, the unemployment rate and wage gain factors suggest that a Fed-induced recession may occur.

Stock Market Performance

Stock market performance is not an accurate predictor of recessions, but it is sometimes a contributing factor to one. The stock bubbles of 1929 (excessive trading on margin), 2000 (dot.com mania), and 2007 (subprime mortgage housing boom) each resulted in a significant loss of capital for investors, a dramatic drop in credit availability for consumers and businesses, and massive layoffs. Each of these bubbles then led to the recession that followed.

However, evidence suggests that recessions don’t always result in major stock market declines when they occur. The graphic below displays the market performance of the S&P 500 Index (Index) during 10 recessions dating back to 1957. It is calculated by measuring the total return of the Index from the monthly start of a recession until the month it ended. Recession dates are determined by the National Bureau of Economic Research.

In four of these recessions, the total return of the Index was positive. Overall, the average total return was -2.24%, and the median total return was -4.90%. Hence, there is little evidence that selling stocks in anticipation of a potential recession—which may not occur—is a strategy offering strong rewards. Of course, past performance is not a guarantee of future results.

In conclusion, the factors analyzed in this report suggest that the primary driver of a potential recession could be the Fed’s continued lifting of interest rates. Hopefully, the Fed will monitor closely the economy’s strength as it determines any future rate hikes. However, post-pandemic evidence suggests that the Fed has made several questionable decisions contributing to our current inflationary environment, so future Fed policy initiatives—such as raising rates higher than appropriate—could lead to a recession.

TMG continues to employ its risk management tools in consideration of a prospective recession and resultant market volatility. Clients who continue to adhere to their financial plan maintain the strongest pathway through this potentially volatile period. Your trusted advisor at TMG is ready to respond to any questions or concerns you might have, and to help ensure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.

Sources: Bloomberg; Bureau of Economic Analysis; Bureau of Labor Statistics; FactSet; Federal Reserve Bank of St. Louis; Federal Reserve Bank of San Francisco; Federal Reserve Board; Goldman Sachs; Morgan Stanley; National Bureau of Economic Research; Reuters; US Treasury; University of Michigan; Wall Street Journal

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