No Recession Hurricane: Light but Steady Rain Instead

As I write, I have Covid and a recession may be brewing, yet I find myself once again smitten with something that can get an unbounded and undisciplined investor in trouble: optimism.?

It’s all relative, of course, and by optimism I mean compared with the gloom that has pervaded the financial markets of late. I have never seen a recession so widely forecast as the next one. To be sure, there is reason for caution, because the Federal Reserve is intent on solving the inflation problem, even at the risk of an economic contraction.

Yet many investors have become so obsessed with?whether?there will be a recession that they haven’t asked the more important questions related to its potential breadth and lingering impact. That long-term impact could well be beneficial if it corrects some of the imbalances that are fueling inflation.

I therefore suggest moving away from the question of “will there or won’t there” be a recession, to analyzing what one might look like, including its?depth,?diffusion, and?duration, the three criteria used by the National Bureau of Economic Research (NBER) when assigning a chronology to U.S. business cycles. That is the best way to assess and position for the?long-term?investment outlook.

No Hurricane

A veritable hurricane is on the way, some say, but I can’t find a radar that can spot it. Instead, my radars indicate that the next recession will feature light-but-steady rain that ultimately sprouts green shoots and feeds hungry investors. That may be difficult to envision amid the current foreboding, but it gets easier once you conduct a pre-recession recession synopsis. Let’s do that.

Though the cause and nature of the 11 economic recessions that the U.S. has experienced since 1948 have varied widely, the depth and duration of each depended greatly on initial conditions and the policy response by the nation’s fiscal and monetary authorities.?

The NBER says “a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” Reduced scope for policy support is why I say the next recession might feature “steady” rain, because the economy will be largely on its own, especially compared with 2020. Yet not all is lost.

A Strong Starting Point

Five relatively strong initial conditions look likely to diminish the depth, diffusion, and duration of the next recession:

1. Housing: Households tend to view their homes as a defensive asset, tending to stay relatively confident in the housing market during economic downturns, save for 2008. Households have good cause to remain optimistic, because the biggest determinant of home prices remains extraordinarily favorable: inventory levels. Figure 1 shows the supply of unsold existing homes expressed in months. That tally stood at just 2.6 months in May, near an historic low. Even if inventories were to double from their current level to 1.2 million units, the supply of unsold homes would still be below 6 months of sales, a figure widely seen as indicating balance between supply and demand.?Demographics are also favorable, with strong birth rates in the early 1990s leading to strong household formation rates. To be sure, the housing sector could well be harmed by weakening in consumer confidence and income growth, two vital market inputs. Yet a shift to a more balanced outlook seems more likely than a lasting or deep contraction.?The same can be said for another big-ticket item: automobiles. Inventories are extremely lean there, too.

Figure 1

Source: National Association of Realtors, as-of May 2022

2. Household balance sheets: Interlinked with the strength of the housing market is the state of household balance sheets. Federal Reserve data indicate that over the past five years, household net worth has increased a whopping $50 trillion to $150 trillion, led by strong gains in housing, which has boosted homeowners’ equity to 69.9%, close to the record of 70.7% set in 1983 and well above the record low of 46% in 2012. The stock market has contributed, too, despite its recent drubbing, with the S&P 500 still up about 50% from 2017. Households held about $50 trillion of equities at the end of March, which means the market decline has likely shaved $10 trillion or so from that figure, leaving a sizable cushion for navigating a downturn. The same can be said for savings balances, which at $18.1 trillion are about $5 trillion above pre-pandemic levels and about $2.5 trillion above the long-term trend line (see Figure 2).?To be sure, more and more people are apt to exhaust their excess saving, especially those most in need, so this metric need be discounted to some extent. Nevertheless, relative to history, data indicate that household balance sheets are strong.

Figure 2

Source: Federal Reserve as-of March 2022

3. Excess labor demand: You probably have heard Fed Chair Jerome Powell cite the difference between the number of job openings (11.4 million) and unemployed (6 million) to illustrate the strength of the labor market. While not a catch-all, particularly because that crude gauge can fail to capture significant regional, sectoral, and other dislocations, data on job openings have proven to be a reasonable indicator of overall labor-market health. The data capture the enormous churning that occurs regularly, including the roughly 70 million “separations” and 78 million new hires seen over the past year. The churning is apt to accelerate in a recession, led by an increase in involuntary separations alongside a decline in new hires. Ideally, the churn will put the labor market closer to balance rather than result in a surge in unemployment.?The supply side of this story may help, because the U.S. is in the midst of a massive wave of retirements, with more people turning 65 this year than any in U.S. history. That’s because there were more births in 1957 than any year last century. The retirement wave will persist until the last Baby Boomer turns 65 in 2029. Low immigration rates and a lack of funding for child-care programs will limit supply, too. Mind you, both are bad for growth in the long run, but in the next downturn they will mitigate any rise in unemployment.?

4. Healthy banks: A weak banking system can threaten an economic recovery following a downturn. Such is the reality of our fractional-reserve banking system, which requires loans to be created faster than they are paid down to avoid the pitfalls associated with debt liquidations, not the least of which is demand destruction. Banks today appear to be in a strong position to provide cash flow to households and businesses in the event of a downturn, according to the Fed’s annual bank stress test, a major innovation emanating from the Global Financial Crisis. The results, released in late June, are striking. All banks tested maintained capital levels that were twice their minimum thresholds in a hypothetical scenario in which the unemployment rate increases to 10% and GDP shrinks by 10%. The test also assumes declines of 55% in share prices and 40% in?commercial real estate prices. Although there is no guarantee that banks will rescue the economy when it falls, history nonetheless suggests that money will find its way to creditworthy borrowers with ideas about generating future cash flows.?

5. Investment imperatives: The war in Ukraine is motivating energy consumers to reduce their dependence on brown energy sources, which will likely spur new investments in green sources. Many countries and companies are apt to view the transition as an imperative, either because of the war or because they are concerned about climate change and reaching carbon goals.?Other investments are set to increase, too, partly as a result of the war, with many businesses scrutinizing their supply chains and viewing them through a national security lens. These will be costly endeavors, which could motivate companies to find offsets, including new investments in productivity-enhancing equipment and software, especially in technology. Scarce labor supplies are apt to increase the motivation to explore such investments. Finally, in a nod to Ronald Reagan, many nations – especially those in Europe – seem likely to embrace the idea of “peace through strength,” urgently boosting their spending on national defense regardless of whether a recession occurs.

Every recession is different, but a common thread is that each has some degree of excess that must be eliminated. I don’t see the sort of excesses that accompanied the savings and loan crisis of the late 1980s, the dot-com bubble of 2000, nor the housing crisis of 2008. Excesses do exist, yet their removal seems unlikely to be as painful as some occasions in the past, because today they are tied to a nemesis: inflation.?

I therefore feel confident in my weather forecast, and I believe a prudent investor should side with the probabilities when constructing a portfolio. Disinflation in the fall and winter months still seems a reasonable bet, and, when combined with signs that economic activity is holding up, investor sentiment seems likely to improve across multiple asset classes during that time.

Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee.?Click?here?for more about Tony.

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