by the Asset Allocation Committee | PDF

Precise recession forecasting is really difficult.  Most recessions occur during periods of tightening monetary policy; however, history shows that monetary policy works with “long and variable lags,” meaning that the impact of rising interest rates doesn’t lead to consistent timing of downturns.  It’s a bit like wanting to schedule an outdoor event over the next 10 days, and the weather forecaster tells you it could rain in an hour or over the next 30 days.  It’s highly likely that he will be correct, but that forecast is useless for your scheduling purposes.  For investors, the key time frame for a recession warning is probably six to nine months.  Financial markets can continue in a “risk-on” mode for a year to 18 months before a recession and so getting overly defensive can hurt returns.  On the other hand, getting a very late warning may not give an investor enough time to adjust portfolios.

In our 2023 Outlook, we suggested a recession this year was “highly probable.”  We could still be right, but it is clear that the clock isn’t in our favor.  In recent Asset Allocation Bi-Weekly reports, we have discussed various reasons why the economy has avoided a recession.  For the most part, the economy has been less sensitive to higher interest rates, and these reports discuss why.  In this report, we will recap those reports to create a guidepost of what could bring about a recession.  For example, if a factor is still in place, it likely would suggest the recession could be further delayed.  On the other hand, if that condition is changing, a recession might be on its way.

“The Case for New Home Sales” (May 22, 2023): One of the primary conduits of tighter monetary policy to slow the economy is through the housing market.  Given the sharp rise in mortgage rates when we wrote our outlook, we were worried about a decline in home prices as such declines have historically been tied to serious downturns.  However, as mortgage rates rose, existing homeowners have stayed put.  Homebuyers are buying more new homes and homebuilders are accommodating these buyers with less expensive homes and by helping with purchases.  Until some factor, such as rising joblessness, forces current homeowners to sell, this situation is likely to continue.  Our take: This factor will likely continue to delay the recession.

“The Green Shoots of Re-Industrialization” (July 3, 2023): As the world deglobalizes, the U.S. is reindustrializing.  Far-flung supply chains, often in nations now deemed hostile, are leading companies, supported by policymakers, to build industrial capacity in the U.S.  Private non-residential construction has been rising sharply.  Given that various policies, such as the CHIPS Act and the Inflation Reduction Act, are just starting to have an effect, this support is in its early stages.  Our take: This factor will likely continue to delay the recession.

“Are Higher Interest Rates Bearish for Risk Assets?” (July 17, 2023):  Higher interest rates are expected to slow borrowing.  We are starting to see rising delinquencies for credit card debt and auto loans.  However, there has been a rise in interest income for savers.  After years of chasing yields in the more risky and esoteric parts of the financial markets, savers are now getting attractive interest rates on low-risk assets, such as T-bills.  This factor may not delay the recession, but it may reduce the downside risk for risk assets.  Why?  The primary beneficiaries of this rising interest income are the wealthy, who also are the majority owners of equities.  Our take: This may not delay the recession but could reduce the risk from one to markets.

“Where’s the Recession? Examining Employment” (August 14, 2023):  In this report, we note that the labor markets received a shock from the pandemic.  The 55+ labor force and employment fell well below trend.  COVID-19 is particularly risky for older people, and we estimate that if this part of the labor market had remained on its pre-pandemic trend, the unemployment rate would be 4.9%.  There is no evidence yet to suggest these workers are returning at a pace equal to the pre-pandemic trend.  The impact on the labor market could be mitigated through immigration, but labor markets over the next few months will likely remain tighter than they otherwise would have been.  Our take: Employers are adjusting to the lack of labor.  Although strike activity is elevated, there are also reports of wage cuts which would suggest employers are adjusting.  This factor should remain in place, but its impact does appear to be waning.  Thus, it may not delay a downturn much longer.

“Fiscal Tightening Looms” (September 11, 2023):  The level of fiscal support has delayed the recession.  The fiscal deficit has widened because of higher spending and falling tax revenue (partly due to the indexing of marginal tax rates; as inflation rose, the tax brackets shifted up).  However, the moratorium on student debt repayments is coming to an end this month.  The Biden administration has tried to soften the blow, but borrowers will be servicing their student loans again, which will reduce the spending power of the affected households.  Our take: This is a worry.  There is some evidence to suggest that these households assumed that the loan payments would never return and thus borrowed to fund other purchases.  If that is correct, this issue could accelerate a downturn.

Overall, the factors that we have highlighted in recent weeks suggest that the recession probably is an issue for 2024.  Tightening fiscal policy is the only real worry, although some of this tightening will likely be offset by re-industrialization.  The metrics on homes is not good; affordability is weak, but without a factor that forces sales of existing homes, we are probably looking at a mostly soft housing market.  It’s worth noting that residential real estate has had a negative contribution to GDP for nine consecutive quarters.  So, it’s not like residential housing is boosting the economy; instead, it is mostly not causing balance sheet problems for households.

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by the Asset Allocation Committee | PDF

To understand the state of the U.S. economy and gauge near-term financial prospects, investors over the last couple of years have focused on issues like the Federal Reserve’s monetary policy, consumer price inflation, labor market indicators, and retail sales.  They seemed to pay much less attention to fiscal policy, except perhaps amid this spring’s Congressional standoff over the federal debt limit.  Our recent work suggests fiscal policy could become a much more important focus in the coming months.  In part, that’s because of the potential for a stalemate in Congress over the budget for the new fiscal year starting October 1.  More generally, it’s also because of the fast-growing budget deficit and looming changes in the government’s income and outlays.

To start out, let’s look at the broad contours of today’s federal budget situation.  In the 12 months ended in July, federal receipts totaled $4.480 trillion, but outlays rose to $6.743 trillion.  The deficit stood at $2.263 trillion.  That shortfall was nowhere near the enormous deficits at the height of the coronavirus pandemic, but it was still much worse than in the prior 12 months.  As shown in the chart below, the expansion in the deficit over the last year reflected both declining receipts and rising outlays.

To understand what’s going on here, let’s first dive deeper into federal revenues.  During the year ended in July 2023, they were down $352.4 billion from the year ended in July 2022, for a decline of 7.3%.  Our analysis shows the decline can be explained entirely by a $408.3-billion drop in individual income taxes, most likely because of lower capital gains taxes after the stock market’s long slide last year, lower wage income as more Baby Boomers and other workers dropped out of the labor force, and an upward adjustment to federal tax brackets because of the price inflation in 2022.  The drop in individual income taxes was partially offset by a modest rise in other receipts, such as Social Security taxes, Medicare taxes, corporate income taxes, and customs duties.

The bigger change came on the spending side of the ledger.  In the year ended July, federal outlays were a whopping $951.8 billion more than in the preceding year, for a rise of 16.4%.  A couple of major outlays fell.  For example, Income Security and Healthcare spending declined modestly.  On the other hand, several big spending types grew sharply.  Because of population aging, a boom in new retirees, and a big cost-of-living increase in Social Security benefits, outlays for Social Security and Medicare grew by a collective $279.6 billion.  In addition, interest outlays were up $182.9 billion from the prior 12 months as outstanding debt grew and interest rates rose.  Most dramatic of all, education outlays ballooned by $453.2 billion compared with the previous 12 months, mostly reflecting the pandemic-era moratorium on student loan repayments and interest.  That moratorium was declared back in March 2020, but final costs of $449.3 billion were recognized only in September 2022, making it look like there was a sudden, temporary spike in education expenditures during that one month (see chart below).

The spike in recognized education expenditures may drop out of the 12-month rolling average beginning with the Treasury report for September 2023, which could then show a drop in spending.  More broadly, as the student loan pause and other big pandemic relief programs come to an end in the coming months, the drop in overall fiscal stimulus could have a noticeable negative impact on demand.  Not only will college graduates lose their student loan subsidies and have to start paying principal and interest again, but daycare centers will lose their operating subsidies, prompting some to close and forcing many, mostly women, out of the workforce.  Of course, the administration’s big, new programs to subsidize infrastructure rebuilding and factory construction will soon begin to pump more money into the economy, but that probably won’t offset all the expiring pandemic outlays.

Without substantial growth in fiscal stimulus in the coming year, a major pillar that has prevented the economy from entering recession will be removed.  Although the tight labor markets from the loss of Baby Boomers and the consequent higher incomes remain as does rising interest income, the drop in fiscal stimulus raises the odds of a downturn in the coming quarters.  Thus, investors need to remain vigilant about a recession, even though the current consensus is calling for continued growth.

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