Capital Ideas^TM

Three questions have weighed on investors’ minds for months: Will there be a recession? How bad will it be? And what comes next?

The US Federal Reserve’s aggressive campaign of interest rate hikes to combat persistent inflation has amplified the risk of recession. Recent banking sector turmoil, which will likely result in tighter credit conditions, could further that risk.

“One reliable indicator of a recession is an inverted yield curve, where the yield on short-term US Treasury bonds is higher than the yield on longer dated bonds,“ says US economist Jared Franz. “Recent activity in bond markets suggests a recession is widely expected. In fact, this may be the most widely anticipated recession in decades.”

While many investors are focused on the timing and severity of the next recession, Franz has turned his focus to longer term questions: What could be the catalysts for a subsequent recovery? And what are some of the implications of that recovery for investor portfolios?

“When an insight is widely held, it can be challenging to benefit from that insight, as it may already be priced into the market,” Franz says. “Instead, investors may be better served by preparing for what I believe will be a stronger than usual recovery, fuelled by a healthy consumer sector.”

Here, Franz shares his expectations for recession and his perspective on a potential subsequent recovery.

Has the US already entered a recession?

I believe we are on the edge of a recession. And with inflation still above the Fed’s 2% target and labor markets tight, the central bank still has work to do. Given the recent banking upheaval, I believe the Fed may temper its approach to rate increases, but I do believe it will be prepared to hike rates until inflation slows further.

I now expect a 1.0% decline in gross domestic product (GDP), or what would be considered a “mild” recession. That would be considerably milder than the 4.5% decline investors experienced during the global financial crisis (GFC) from 2007 to 2009, and closer to a more conventional recession. This is not to diminish the impact of recession on individuals. Recessions, no matter how mild, can be painful.

A weakening housing market is another risk factor. Sales fell in March, resulting in home price declines for a second straight month. But from here, I expect that prices may have a further 10% downside followed by a reacceleration. This will help limit any deterioration in household balance sheets, which may provide a boost to consumer confidence.

Will the next recovery be stronger or weaker than prior ones?

If there is one, I believe there are two reasons a recovery will be stronger than prior cycles. First, there may not be a need for large-scale deleveraging like there was during the GFC. Because so many companies have been expecting economic weakness, businesses have taken action, delaying orders to work excesses out of the economy. So, while a recession is likely this year, I expect it to be somewhat shallow.

Second, the US consumer sector is strong relative to past cycles. Healthy job markets, wage growth and household wealth should be key catalysts for a more robust recovery.

Certainly, the US labour market has been softening recently, and a recession of any magnitude will likely drive unemployment higher as companies announce layoffs. But the labour market has shown continued strength, with 236,000 jobs added in March. Why is that? Structural changes in labor markets have shifted labor supply and demand dynamics.

At the end of March, the unemployment rate stood at 3.5%, near multidecade lows. As the economy slows, unemployment will rise from here, but I believe it will peak around 5.0% and fall more quickly than we have seen in prior business cycles. And, since the start of the pandemic, work-from-home trends, along with the reshoring of supply chains back to the US and the development of sustainable energy, have bolstered real wages, particularly for middle- and low-income workers.

What’s more, at this point in the cycle, consumers have low debt relative to levels coming out of the GFC or even other more typical recessions. At the end of 2022, household debt service as a percentage of income stood at 9.7%.

What other factors could support a consumer-led recovery?

I expect moderating inflation to further support consumer strength. While it will take some time for the Fed to get inflation down to its 2.0% target, I believe it will be contained near 3.0%. Academic studies have shown that consumer spending has tended not to be significantly impacted by inflation around 3.0%. Contained inflation will likely boost consumer confidence. And, if wages hold up, it can feel like a real wage boost. I also expect inflation to edge toward 2.0% to 2.5% by 2025.

I believe we’ll also see productivity gains from automation and the increased adoption of artificial intelligence. This may provide an economic tailwind by helping to manage rising labor costs. That said, I do not expect such productivity gains to offset hiring needs in the near- to mid-term.

I also expect we will see stronger housing demand coming out of the recession. Changing demographics and rising household formation (a group of individuals who intend to live together), suggest a likely rebound in housing demand. I expect the popularity of working remotely to drive demand for housing development in suburbs, areas beyond the suburbs and second-tier cities, as well.

What does it mean for investors?

Solid labour market fundamentals, household balance sheets and moderating inflation could in my estimation lead to 3.0% growth in the US consumer sector. This is important because consumers account for about 67% of the US economy. It is important to emphasise that a recession will cause some contraction in the labor market, but I expect the labor market to rebound.

Strong wages and consumer confidence could boost consumer spending, providing an uptick in a range of industries, including travel and leisure. What’s more, a housing market recovery could provide a tailwind not only to construction spending, but also spending for other durable goods, like household appliances.

Historically, the stock market has tended to anticipate recoveries, rebounding ahead of any turn in the economy.