Assessing Recession Risk: Is the Economy Rolling Down a Hill or Falling off a Cliff?

Assessing the Economic Landscape

When and if the US will fall into a recession has been a topic of conversation in political and financial circles and at family dinner tables ever since inflation reared its ugly head in 2021. When most people think of a recession, they consider the general definition: "two consecutive quarters of negative GDP and significant, widespread, and prolonged downturn in economic activity." Understandably, we make the comparison to the most recent recession, that being the global financial crisis of 2008, where we saw unemployment stay above 8% for 2 and 1/2 years, the S&P 500 fall 57% peak to trough, and home prices decline by 30% seemingly all at once.

Because of this narrow definition, the proposition that the US economy is on the cusp or currently in a recession is often scoffed at. You likely would hear jeers that the stock market recently reached an all-time high, home prices in the US declined a mere 11% before rebounding, and the most prominent rebuttal is that unemployment remains at historic lows, 3.7% to be exact.

But to see the complete picture, we must get out of tunnel vision and narrow definitions and appreciate the difference between correlation and causation. The theory that a recession cannot occur without high unemployment levels is based on the common misconception that unemployment is a leading indicator when, in reality, it has a substantial lag. Recessions are caused by a financial or economic catalyst, leading to decreased demand for goods and services. In turn, a recession leads businesses to reduce their workforce to cut costs, followed by a rise in unemployment, not the other way around.

Current Economic indicators

What makes our current economic environment unique is that rather than experiencing widespread economic collapse, it can be argued that recessions have been occurring but in isolation, jumping from one sector of the economy to another. For instance, manufacturing thrived during the first year of the pandemic due to the skyrocketing demand for consumer goods as people were quarantined and locked in their homes with no services to buy. However, we began to see declines in new orders, a leading indicator of future demand beginning to stall in early 2021, falling into contraction by the beginning of 2022, and falling by 37% overall.

Next up was the real estate sector, which may not have seen the implosion of home values as it did in 2008, but if we look at the number of home sales, it's an entirely different story. Home sales peaked at the end of 2020 and the beginning of 2021 at an annual rate of around 6.7 million. They began their collapse in January 2022 and have been deteriorating ever since, culminating in December 2023 at a yearly rate of 3.78 million, a decline of 43%, well in line with recession-level weakness.

Revenge spending and the Labor Market

So, what has been stopping the economy from falling off a cliff? None other than the most significant driver of the US economy, consumer spending, which makes up around 70% of the US GDP. This sheds light on why the economy remains resilient. Spending was initially supported by the massive fiscal and monetary stimulus, aka stimmies, during the pandemic, which provided people with excess savings and disposable income. More recently, wage growth has supported consumer health due to the supply-demand imbalance in the labor market. At one point, there were two job openings for every unemployed person.

To attract qualified applicants, companies became willing to offer significant wage increases and signing bonuses. In fact, between April 2021 and March 2022, 50% of employees who switched jobs saw their real wages (wages minus inflation) increase by 9.7% on average. This boost in income supported additional spending.

This time, consumers flocked to the services sector, inspiring the term "Revenge spend." As COVID lockdowns were removed and services opened up, consumers took their disposable income and splurged on the experiences that were previously unavailable, such as travel, leisure, and hospitality; this, in turn, supported the surge of hiring in these industries and considering the sector employs 80% of all US, workers explains the resilience in the labor market.

Where could a recession be rolling to next?

Revenge spending cannot go on forever. There are already signs that the consumer has exhausted their excess reserves. Since June of 2023, the spread between disposable income and spending has been negative, meaning spending is exceeding income, and consumer balance sheets are deteriorating.

More evidence of this can be found in consumer credit card debt reaching a mind-numbing 1 trillion dollars, a 50% year-over-year increase, along with an increase in the utilization of buy now pay later programs, especially by younger consumers, and an acceleration in auto loan defaults, particularly in the lower-income demographic.

Unfortunately, as consumer debt levels increase, banks inevitably become more conservative. They respond by increasing their loan loss reserves and tightening lending standards, which limits credit availability, further restricting consumer spending.

And you guessed it, as demand for services begins to slow, so will economic growth, and companies will have no choice but to cut costs by further reducing employee hours, ultimately leading to more layoffs. This cycle exemplifies that unemployment is the reaction to economic weakness, not vice versa.

Federal Reserve's Role and Monetary Policy

Over the past year and a half, Jerome Powell, chairman of the Federal Reserve, made it clear that the fight against inflation would be their top priority. Bringing inflation down to its 2% target would require the central bank to increase interest rates, suppressing the demand for credit and slowing down the economy.

They certainly put their interest rates where their mouth is by raising the fed funds rate 22 times in those 18 months, the fastest pace in history. In the same breath, they acknowledge that a slowing economy frequently corresponds to an increase in unemployment, and this was collateral damage they were willing to accept to achieve their inflation target.

Considering the nature of monetary policy and interest rate hikes, it's important to remember that their full impact on the economy often has long and variable lags, typically spanning 18-24 months. At the time of this article, it has been 22 months since the initial rate increase in March 2022, so we might still be awaiting the complete effects of monetary tightening.

Encouragingly, current trends show a gradual decline in inflation, and we haven't experienced an uptick in unemployment rates (though we've already discussed why that may be). This situation provides hope for those advocating for a 'soft landing.'

Potential Risks and Future Outlook

Inflation coming down is certainly good news, but this doesn't mean the prices of groceries, insurance, or rent are coming down, only their rate of change. With wage growth slowing and the cost of living remaining elevated, consumer spending will slow, and the boom in the service sector will need to take a break. Again, considering that the service sector employs such a significant portion of the US labor force, it seems an increase in unemployment is in the cards for 2024.

A central question will be how the Fed will respond once the unemployment rate begins to climb. Will they feel compelled to respond by easing monetary policy by lowering rates? This approach could backfire as rate cuts could reaccelerate inflation, boost GDP, lower unemployment, and trigger another aggressive tightening cycle. That, in my belief, would lead to a hard landing, a.k .a. "falling off a cliff" scenario.

I believe this potential scenario can be avoided, but the Fed needs to be prudent and maintain its data-dependent approach. Suppose unemployment begins to tick up and the service sector begins to slow, but other sectors of the economy remain strong. In that case, this is likely not a signal of a widespread economic collapse but simply the service sector's turn in the sequential nature of the rolling recessions. The economy needs more stability, not a significant drop in interest rates, and rolling recessions provide each sector a bit of a reset, which would likely create better supply and demand fundamentals.

Where Do We Go From Here?

Whether we are near or at the end of the current economic cycle is debatable. The beginning of a recession is always declared in retrospect. It is not until midway through or near the end that we realize we are in the midst of a recession; the best we can do is deploy strategies and pay close attention to data and indicators to assess the trajectory of the economy.

Considering the Fed may be at the end of its tightening cycle, the state of the labor market may become their primary focus. A surge in layoffs serves as an early warning sign, indicating shifts in business confidence and operational strategies. Subsequently, initial unemployment claims provide insights into the number of individuals freshly seeking unemployment benefits, reflecting emerging trends in job security. Equally important is the analysis of continued claims data, which sheds light on how long it takes people to find a job.

Beyond the labor market dynamics, if we begin to see emerging patterns in the housing, manufacturing, or construction sectors indicating a second downturn, this could signify clues to the broader economic downturn and a hard landing. For instance, indicators such as pending home sales and home price reductions in the housing sector can signal shifts in consumer confidence and financial stability. Manufacturing purchasing managers' new orders and input costs are barometers of industrial health and inflationary pressures.

In the end, this is not a prediction. We will need to wait and see whether these indicators point to a resurgence in inflation, a deterioration in key sectors, or a stabilization of the economy. All I hope to do is provide a bit of clarity and offer a nuanced and multifaceted perspective on the economic landscape.