Recession Risks Are Rising

Recent developments suggest the odds of a recession in 2022 are increasing. 

Fiscal Cliff

The response to COVID included massive government support for US consumers. These “transfer payments” supported many millions of unemployed over the past two years, and they were highly successful in generating a speedy economic recovery. However, many of those support programs, including stimulus checks, extended unemployment payments, child tax credits and student loan moratoriums, have expired or are about to expire. As you can see in the chart below, transfer payments grew by about $1.5 trillion from 2019 to 2021. As a percentage of GDP, the transfer payments were up over 5% from 2019 to 2021 to nearly 20% of GDP. If just half of those transfer payments go away, it could be a drag of 2%-3% on economic growth in 2022. This will be a pretty stiff headwind to overcome. 

Inflation

Inflation is very high and rising. More troubling still, the categories of goods and services driving the inflation are very much non-discretionary in nature. Outsized growth in food, energy, health care, child care, and shelter expenses will continue to have the most impact on low- to middle-income families. And though incomes on the lower end have been growing at a solid pace in recent months, the increases have not been enough to cover the rising cost of such necessities. The Ukraine crisis will exacerbate the inflation in non-discretionary categories as Russia and Ukraine supply a big portion of agricultural and energy commodities to the world markets. The chart below shows that growth in inflation-adjusted average hourly earnings has been negative for nearly a year now. Continued price increases for necessities will create additional hardship for low- to middle-class families, leaving them with less money to spend elsewhere.   

Interest Rates

Economists love to talk about how strong consumer balance sheets look these days. They say that assets are high, debt levels are reasonable, and the cost to service that debt is very low. However, this argument misses two crucial points. First, it makes little sense to look at consumer debt levels in isolation. Consumers are ultimately responsible for government debt, and so the fact that consumer debt has been effectively replaced by government debt (due to tax cuts and stimulus initiatives) should not be extremely encouraging. Yes, the federal government has greater capacity to borrow at lower rates, but we’re all on the hook to pay this debt off eventually. Second, we cannot simply look at the consumer balance sheet in aggregate. We need to look at the breakdown of assets, debt and net worth. Yes, the wealthy have done fabulously well in recent years due to huge increases in incomes and asset prices. But the majority of Americans are not that much better off. And we all know that the bottom half of the income spectrum is more inclined to actually spend their money (rather than save), driving economic activity in the process.

Falling debt-service costs have been an economic tailwind for many years. The chart below shows debt-service costs as a percentage of Disposable Personal Income (DPI) and GDP, along with average annual yields for the 2- and 10-year Treasury bonds. It is fairly obvious that despite big increases in consumer debt over the past three decades, declining interest rates have been the more dominant factor since the Great Financial Crisis. Now that interest rates are rising, reflecting both higher inflation and anticipated interest-rate hikes by the Fed, debt-service costs are likely to go from a tailwind to a headwind. And though most of the impact will likely take place over a number of years, it’s hard to see debt-service costs continuing to decline now that interest rates have already risen fairly dramatically from the lows. It also stands to reason that sharply higher mortgage rates will have a negative impact on the heretofore sizzling housing market. 

COVID

Recent news reports suggest China and Europe are in the initial stages of another COVID outbreak. Though details are sparse right now, infection and hospitalization rates seem to be on the rise again. Historically, infection rates in the US have trailed those in the UK by a couple of weeks. And the UK’s vaccination rates are much higher, so there is reason to expect some economic disruption in the US. In addition, economic shutdowns in China could continue to threaten supply chains and exacerbate shortages and inflation. 

China

Yesterday, the Chinese government confirmed a 5.5% growth target for its economy in 2022. That 5.5% would be the lowest growth rate since 1991 and is well below the 8.1% reported for 2021. Some of the factors contributing to the uncertain outlook are a slump in the real estate market, a new outbreak of COVID, and the war in Ukraine. Given that China has been the economic engine for the world for a long time now, a big decline in Chinese growth this year will have an impact in the US and elsewhere.

Confidence

Consumer confidence had been steadily declining even before the Ukraine crisis. In fact, the University of Michigan survey is currently at its lowest level since 2011. If consumers aren’t confident, they usually don’t spend as freely.

Wealth Effect

Faithful readers of these Market Commentaries know that I have concerns about the concentration of income, wealth and spending in the US. I believe a broader dispersion of financial strength would lead to better and more sustainable rates of economic growth. This is not a social comment, but rather a formula to increase the velocity of money and better sustain fundamental economic growth. That said, the US economy’s heavy dependence on a relatively small percentage of affluent consumers means that the economy may also be susceptible to falling asset prices. In the chart below you can see that stock and bond prices are well off their highs. 

Labor Shortages

The number of job openings in the US currently exceeds the number of “unemployed” by about 5 million. There are various explanations for the labor shortage, and they include fear of COVID, long COVID, deceased from COVID, lack of child care, extended unemployment and other government benefits, skills mismatches, and early retirements (due, in part, to soaring prices). But there is a price for everything. Rising wages should draw more folks into the labor force over time. However, the wage gains necessary to satisfy the labor demand may exacerbate inflationary pressures. Economists call this a “wage/price spiral.”

Russia Crisis

The crisis in Ukraine obviously has everyone on edge. Russia and Ukraine provide an outsized amount of the world’s commodities, to include food, energy and industrial metals. Any disruption in the supply of those commodities will exacerbate inflationary pressures. But the crisis is also likely to affect the capital markets. The pressures on the Russian currency, the ruble, are likely to lead Russia to default on its dollar denominated debt. This could have ripple effects throughout the fixed-income markets. But Russia is not the only emerging-market country with dollar-denominated debt. As the dollar continues to strengthen in a flight-to-safety trade, it becomes more difficult for emerging-market countries to make payments on their own dollar-denominated debt. Could a likely Russian default lead to contagion?

Conclusion

On balance, we see the risk of recession as higher than it was at year-end 2021. There are obviously still a lot of uncertainties, and so the deteriorating outlook is by no means definitive. It is also possible that any potential economic downturn could be short-lived, especially if there is a quick resolution to the Russia/Ukraine crisis. Still, the signs are accumulating. We see the following as factors that will work to ameliorate the aforementioned headwinds for stock investors. 

• The most important gauge of consumer well-being is the labor market. As long as jobs remain plentiful, the magnitude of any economic downturn is likely limited. 
• Though the Fed has yet to increase interest rates even once, the bond markets are already incorporating as many as 7 or 8 hikes ahead. The yield on the 2-year Treasury note is up from close to zero to 2%. If the economy deteriorates, it’s a long way down to zero. And the Fed could also resort to growing its balance sheet again by buying longer-term bonds. So if the economy runs into trouble, there is room for interest rates to fall and provide some stimulus (though this assumes inflation comes down as well).
• There is also ample capacity for fiscal stimulus. We see the bar as fairly high given deficits and the strength in the labor market, but this option is always available (and likely to be used in times of crisis). 
• The Fed’s current estimate for 2022 GDP growth in the US is 2.8%. There is a long way to go until we reach recessionary (negative) growth rates.
• Though we tend to de-emphasize aggregate economic metrics, it is estimated that consumers are carrying some $2-$3 trillion in excess savings right now. These savings can be viewed as deferred economic growth that may cushion the blow of an economic slowdown. There is also a sizeable amount of pent-up demand, especially for services, following COVID lockdowns, and infection rates have plummeted (for now). 
• The S&P 500 and Nasdaq have already dropped over 10% and 18.5%, respectively, from their highs. There are many excellent companies down much more than that. Therefore, we believe that some probability of a recession is already incorporated into current stock prices. I would note that last week, Goldman Sachs increased the probability of a recession this year to about 35%. If we assume stock prices fall by about a third in a typical recession, then this increased probability of recession is already reflected in current stock prices. 

The news is never either all good or all bad. That’s what makes markets. We will continue to weigh the positives and negatives and look for opportunities where they surface.