The Recession that Didn’t Bark

Subscribe to the?Notes on the Week Ahead newsletter?to receive it directly in your inbox.

A famous Sherlock Holmes story concerns the abduction of a race horse and a guard dog that didn’t bark.?For those who haven’t read the story, I’ll skip over the reason for the dog’s silence.?The point is he didn’t bark – no alarm was raised – no actions were taken - and the horse disappeared.

Entering the fourth quarter of 2022, the U.S. economy is teetering on the edge of recession.?However, it is a recession that has been delayed and potentially softened by an excess demand for labor, the lack of over-building in the most cyclical sectors of the economy and healthy bank balance sheets.??

That being said, it could also be a recession that lingers.?A doubling of mortgage rates, the highest real exchange rate in almost 40 years, continued income inequality and weak demographics could all hamper recovery. Moreover, this could be the recession that didn’t bark – with only a moderate rise in unemployment and no overwhelming shock, unlike the Great Financial Crisis or the Pandemic Recession.?If this is the case, then neither the Federal Government nor the Federal Reserve are likely to react quickly to combat the downturn.

Without such action, growth could remain anemic and inflation could drift below the Fed’s 2% target.?Ultimately, this could lead to a reduction in the federal funds rate back to accommodative levels and set up a period of slow growth, low inflation, low interest rates and high profit margins.?Such an environment would be very unsatisfying for those looking for an improvement in living standards after years of inflation followed by stagnation.?However, it would provide strong support for today’s beaten down bond and stock markets.?

The Risk of Recession

Economic data from last week continued to point to the risk of a recession emerging in the months ahead.?Revisions to the national income and product accounts still show falling real GDP in both the first and second quarters of 2022.?However, as we outline on page 20 of our new fourth-quarter 2022 Guide to the Markets, given the continued strength of the labor market, two quarters of negative real GDP growth is not sufficient to categorize the economy as being in recession.??

Going forward, a strong recovery in international trade numbers for July and August suggest a positive read on real GDP growth for the third quarter.?However, thereafter growth could oscillate between negative and positive readings as the economy battles some strong headwinds.??

In particular:

• Consumer spending will be hampered by continued fiscal drag, the negative wealth effect of the stock market slump, the knock-on effects of weaker home building and home sales, and still slow population growth.?However, steady growth in wage income and a gradual increase in auto sales as inventories recover should result in slightly positive consumption growth.
• Residential construction, by contrast, is almost certain to see a steady decline in the face of a startling increase in 30-year fixed rate mortgage rates from 3.11% at the end of last year to 6.70% as of last week.??
• The latest GDP revision boosted second quarter real inventory growth to a $110 billion annualized pace.?This is well above the roughly $50 billion in annual accumulation necessary to maintain a steady inventory/sales ratio and returning to that more modest trend should also chip away at GDP growth in the year ahead.
• Most business fixed investment, while looking strong in the third quarter, should falter going forward reflecting higher interest rates, declining corporate margins and pessimism concerning the economic outlook.??
• While monthly trade data suggest an improvement in net exports in the third quarter, weak growth overseas and an almost 20% appreciation in the dollar should boost real imports and reduce real exports thereafter, also slowing down the U.S. economy.

There are some more positive potential areas including increasing investment in energy infrastructure and more state and local government spending.?However, at best, real GDP growth looks like it will be close to zero in the year that ends in the fourth quarter of 2022 and not much more than 1% in the following year.

Despite very weak real GDP growth, the huge excess demand for labor which emerged as pandemic effects subsided, should keep payroll job growth strong for a while and limit any immediate increase in the unemployment rate.?The August job openings number, due out on Tuesday, and September employment numbers, due out on Friday, should shed fresh light on the speed with which labor market imbalances are fading.?However, the most likely path for the labor market is one of delayed rather than cancelled reaction.?Once job openings have retreated to more normal levels in 2023, payroll growth will likely falter and the unemployment rate will likely rise in reaction to a prolonged period of anemic or negative GDP growth.

Inflation should also continue to ease slowly.?The OPEC+ group will meet this week to consider output cuts with Russia pushing for greater reductions than other countries.?However, the broad slowdown in the global economy and the strength of the U.S. dollar are both undermining commodity prices with the Bloomberg Commodity Index now down 18% from its June peak.?Some other areas of inflation also show improvement, including recent declines in used car prices, and a combination of constrained consumer spending and diminished bottlenecks should help inflation moderate going forward.?Even with this, solid wage growth and the lagged effect of shelter costs on inflation suggests that core consumption deflator inflation could still be running at close to 3.5% year-over-year by the fourth quarter of 2023.

That being said, 3.5% is a substantial improvement from the 4.9% reading in August 2022 or the peak of 5.4% seen in February of this year.?Moreover, by 2024, rising unemployment should be having a significant impact in reining in both wage growth and rental increases and this could well allow inflation to drift below the Fed’s 2% target.

The Consequences of a Delayed Policy Reaction

Crucially for investors, the mildness of any GDP declines combined with the delayed reaction of inflation and unemployment to those declines, could delay any policy response from the Federal Reserve.?If, as futures markets suggest, the Fed raises the federal funds rate to a peak of between 4.25% and 4.50% by early next year, it may well maintain that rate and its program of quantitative tightening for many months longer than would seem appropriate given the trajectory of the economy.

Fiscal policy would likely be even slower to react to economic weakness, given the probability of divided government following the mid-term elections, with any meaningful fiscal stimulus likely postponed until after the 2024 presidential election.??

However, this does suggest that, in 2024, the Federal Reserve may find itself playing a familiar solo game of stimulus in catchup mode.?This could force it to halt quantitative tightening and cut rates as inflation drifts below 2% and unemployment moves higher.?This easier monetary policy would likely have only minor and lagged impacts in stimulating the economy and might end before the federal funds rate dipped below 2% as the Fed would probably like to avoid a return to an environment of negative real rates.?Such a pivot from the Fed in the face of domestic economic weakness could also help drive the dollar down from its lofty levels, boosting both U.S. corporate profits from overseas and the return on foreign financial assets.?????

All of this suggests a potential return to the slow-growth, low-inflation, low-interest-rate and high-profit-margin environment that prevailed in the United States before the pandemic and which was so supportive of both stocks and bonds.

Of course, for many of those trading in today’s markets, the prospect of difficult times over the next year followed by better financial conditions in 2024 is not exactly alluring.?For those whose income and employment depend on quarterly results and one-year numbers, a path to better long-run returns has less relevance.??

However, for long-term investors, long-term returns are whole point.?For most, a bruising first nine months of 2022 have taken a very large bite out of those returns, as we show on page 62 of the Guide to the Markets.?However, this leaves valuations in a much better place, with U.S. stocks in general and value stocks in particular trading well below long-term average P/E ratios, international equities looking significantly cheaper, and bonds offering both the income and portfolio protection characteristics that they generally lacked at the start of the year.?In short, while this is a painful time to review portfolio returns, it is an important time to consider logical portfolio positioning.??

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.”).?