Complacent Optimism on Soft Landing and the Dangers Ahead

Outlook on U.S. economy has slowly turned positive in last two months and investors’ complacency has crept in as markets increasingly price a friendly disinflation with a soft-landing scenario, helped by optimism around economic impacts of AI.

JPMorgan Chase on Friday scrapped their recession call, joining a growing Wall Street chorus that now thinks a contraction is no longer inevitable. While noting that risks are still high and growth ahead is likely to be slow, JP Morgan’s Chief Economist Michael Feroli told clients that recent metrics are indicating growth of about 2.5% in the third quarter, compared with previous forecast for just a 0.5% expansion.

Earlier last week, Bank of America’s chief U.S. economist Michael Gapen also threw in the towel on his recession call, telling clients that “recent incoming data has made us reassess” the forecast. The firm now sees growth this year of 2%, followed by 0.7% in 2024 and 1.8% in 2025. Gapen isn’t alone in his shifting view of the U.S. economy, either. Recently, Goldman Sachs also lowered its probability for a U.S. recession to 20%, down from 25%. And after warning that a “mild recession” was coming within a year just months ago, Federal Reserve Chair Jerome Powell said his staff are?no longer forecasting a recession?at July’s Federal Open Market Committee meeting.

But despite the newfound optimism of by BofA’s Gapen and his peers, he concluded his research note with a warning. “While we are removing our outlook for a mild recession and replacing it with a soft landing, we acknowledge that we are moving to the outcome least supported in the postwar period,” he wrote, noting that there have been 11 recessions, but only three “soft landings” since World War II. “A lot still has to go right.”

We agree that indeed a lot still has to go right for a soft-landing scenario to materialize. In contrast, markets have already priced the best-case scenario in our view. Latest Nonfarm Pay rolls data last week showed that the U.S. economy added fewer jobs than expected in July, but average hourly earnings rose 0.4% (up 4.4% year-on-year) and the unemployment rate fell to 3.5% from 3.6% in June, levels last seen more than 50 years ago.?Solid wage gains and a decline in the unemployment rate point to continued tightness in labour market. Annual wage gains have shown no meaningful decline throughout 2023 and remain too high to be consistent with the Fed's 2% inflation target.

Given that the US economy remained resilient despite rising rates, labour market still tight, wages continued to rise and core inflation at 4.83% is still ways away from central bank’s 2% target; it’s likely the Federal Reserve is going to end up with rates either too high or as high as they are for too long until economic weakness is evident. Effects of monetary policy tightening on economy are slow moving and therefore its often more difficult to decide when to stop raising rates and start lightening the pressure on households and businesses by cutting rates.

Contrary to market and street expectations, New York Fed indicator?which tracks the difference between 3-month and 10-year Treasury yields is pointing to a 66% chance of a contraction in the next 12 months. The inverted yield curve has been a reliable recession predictor in data going all the way back to 1959.

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Recession starts are rarely acknowledged as consensus in real time; officially, they are only declared in hindsight. It is hard to predict what might happen with the economy when rates have risen substantially and with such speed. Economy could look just fine and suddenly begins to crumble beneath the surface. In fact, that is why the Fed is?keeping its options open?when it comes to future policy and does not want to commit to how much, when or even whether they would raise rates again. There is still quite a bit of uncertainty around the inflation outlook with robust wage growth and energy prices starting to rise again; which makes policy decisions from here very difficult. Therefore, we believe that the current soft-landing optimism?is a little premature. We have seen similar optimism voiced in previous downturns in 1989, 2000 and 2007. For example, in October 2007, the FOMC was?opining?on the economy’s resilience amid an overall soft-landing narrative. It was that same month that the S&P 500 topped out, with the Great Recession starting just two months later. Each time the US economy plunged into recession, unemployment has shot up, businesses closed, and growth reversed. That shows how hard it is to arrest a slide once it begins.

Amongst many other indicators which threaten the "soft-landing" scenario is Fed's quarterly Senior Loan Officer Opinion Survey (SLOOS) released last Monday which suggests credit tightening is ongoing. SLOOS survey showed that the U.S. banks reported tighter credit standards and weaker loan demand from both businesses and consumers during the second quarter. Banks also expect to further tighten standards over the rest of 2023.

As per JPMorgan economist Daniel Silver, "The degree of tightening in recent quarters looks pretty significant by broad historic standards", He further noted that in the past such tightening has generally been associated with recessions. The data "are not a guarantee of a recession to come, but the tightening evident as of late suggests that the economy should slow."

Consumer spending is a key driver of economic growth. Amidst the significant credit tightening, the?student loan pause officially ends?at the end of August after more than three years. The moratorium suspended payments, froze interest, and stopped collections for most federal student loan borrowers in response to the Covid-19 pandemic. After the student loan pause ends on August 31, interest will immediately start accruing the next day — September 1. Student loan payments will then start up again in September. Risks are that the economic optimism and resilience of the consumer sector can soon come to a rapid halt as personal finances capitulate, and consumers run out of cash.

According to the Brookings Institution’s report published last Tuesday, U.S. consumers’ Real income growth has slowed to levels below the pre-pandemic?trend. Meanwhile, consumers kept their spending habits from a couple of years ago, when forced inactivity and Covid government support payments bolstered their savings. Much of that wealth gained since 2019 has dissipated by the first quarter of this year. “If households were to sustain their current spending trends and increasingly finance spending with borrowing, financial health could deteriorate in a worrying way,” the analysts wrote.

We would therefore warn investors that equity market?gains should not be mistaken for confidence that there’s no recession on the horizon. On the contrary, most inputs – the yield curve inversion, tighter credit conditions (SLOOS Survey), Manufacturing contraction, slowing services sector and lagged effects of one of the most aggressive policy-tightening point towards greater risks of a delayed US recession.

And yes, equity investors need to worry if a recession is in the making given the close relationship between the economy, earnings, and asset prices over time. There have been 10 official U.S. recessions since the S&P 500 was established in 1957. The worst S&P 500 decline occurred during the?Great Financial Crisis when the index plunged as much as 55% below its peak. However, that was a much more severe recession than normal. The average S&P 500 decline during post-World War II recessions is around 29%. This average is skewed, though, in part due to the especially steep sell-off during the 2007-09 recession. The median decline is around 24%.

Now, if we take a step back and assume that our recession argument is proven wrong in coming quarters; there is still a clear argument that in the short-medium term markets have run well ahead of fundamentals. The surge in PE Multiples suggests that all the good news is priced in. Consider this:?at 20.44x, the multiple is as high as it has been in the past 50 years,?with the exception of the tech bubble and the post-COVID rally.?

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