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In my previous quarterly projections, I called for a recession to possibly begin as soon as the fourth quarter of this year (current quarter) and is more likely to occur in the first and second quarters of 2023.
Based on the recent and continued strength of the labor markets and still healthy (but deteriorating) consumer balance sheets, the likely timing of the recession is now the second and third quarters of 2023.
In this blog post, I’ll discuss factors contributing to a looming recession and the likely depth and duration of the coming downturn.
Summary
- The economy is likely to continue growing modestly through the end of the year and possibly into the first quarter of 2023.
- However, economic activity should begin to soften by the second quarter including a gradual uptick in the unemployment rate.
- As long as inflation starts to come down as expected next year, the recession should be short-lived and fairly mild by historic standards.
- Both economic activity and employment should pick up by the end of the year (fourth quarter) as market rates abate.
- Expect the labor market to return to full employment within a couple of quarters of the end of the recession. Continuing pressure from aging demographics will keep labor markets tight in the U.S. for many years to come.
Tightening Financial Conditions
Continued tightening of financial conditions as evidenced by the Goldman Sachs index and the inverted yield curve are indicators that the likelihood of recession is at 95+% in the coming year.
In fact, the yield curve has been inverted since July 9 when CPI came in at 9.1%, and has remained there since. As a reminder, an inverted 10-year/1-year treasury curve has preceded every recession in the past 70 years, and it has not inverted without a recession following during the same period.
Net Interest Margins
Interestingly, some financial institutions have been able to increase net interest margins, recently, despite the yield curve as they have moved up lending rates faster than depository rates.
However, market forces will catch up and squeeze these margins, resulting in more conservative lending and a slower economy. This is one reason why the inversion of the yield curve has been such a powerful predictor of recessions.
Financial institutions borrow in the short term and lend out in the long. When long rates are lower than short, net interest margins get squeezed causing a pullback in lending. The resulting choking off in credit (tightening financial conditions) causes the predicted recession to become reality.
Consumer Balance Sheets
Consumer balance sheets continue to deteriorate as inflation outstrips wage gains. Consumers are not only saving less, but they are also increasing their debt to try and normalize their spending. Unsurprisingly, credit card debt and home equity borrowing have increased significantly this year.
Additionally, much of the savings amassed by households during the various pandemic stimulus rounds are now beginning to runoff at a significant clip. In fact, excess savings has fallen by 1/3 this year. With over a trillion dollars still there, consumers may be able to hold on longer than originally thought.
The combination of drawing on savings and leveraging up by consumers will delay the onset of the recession, but not prevent it. Simply put, there is a limit to how much consumers can afford to do these things before spending starts to slow down.
Duration and Depth of the Downturn
Most economists are predicting the recession will be shorter in duration and shallower than average downturns.
While this still seems to be the base case given the strength of the labor markets and relative health of the financial system (compared to previous business cycles), there is an increasing chance for a harder landing.
The longer inflation remains elevated and the Fed has to continue aggressively raising rates and holding them higher, the odds of a longer and deeper recession increase. Most forecasts for inflation this summer, including the Fed’s, called for headline inflation to be around 6-6.5% and core to be around 4.5% by year’s end.
This now seems virtually impossible. Headline might get below 7.5% by year-end and core will certainly be above 6%.
For 2023, inflation projections are for the consumer price index (CPI) to end the year between 2.5-3.5%. Given the continued upside surprises on recent inflation readings, it is more likely that inflation will still be north of 4% by the end of 2023 and return to the Fed’s target of 2% in 2024.
It still seems likely that unemployment will peak between 5.5-6% next year as compared to the typical 7-10% seen in most recessions. This, in turn, will limit the negative feedback loops that often drive the economy down in a recession.
In short, when most people still have jobs, bills get paid and consumption holds up. However, the risks to this outlook are to the downside at the moment given the outlook for financial conditions and the stickiness of high inflation readings as of late.
As we brace for continued tough economic times, it’s more important than ever for financial institutions to arm themselves with information about weathering the turbulence ahead. Click the banner below to automatically download the full Q4 2022 Economic Outlook for Financial Institutions.
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