Is a recession still required?

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When we came into the year, a moderate recession in most developed economies seemed a highly likely outcome. I wasn’t too worried about a market fallout, however, because investors had become pessimistic back in autumn 2022 and stocks had already fallen substantially. The Federal Reserve’s survey of external analysts shows that historically the economy is already in recession before economists realise it, but this time analysts were looking ahead.

Chart 1:

One might have thought that the failure of three regional US banks would have only made matters worse, for the US at least, and added to the drags already underway from higher costs and higher interest rates.

However, the timeliest data on economic activity – the Purchasing Manager’s surveys – are actually improving. And they have been for most of the year. While the manufacturing sector is not doing great, the service sector is practically booming. This makes sense given we are still adjusting to the post pandemic overaccumulation of ‘stuff’ and an under accumulation of ‘experiences’. ?

Chart 2:?

Chart 3:

Consumer confidence is also recovering in most regions. Looking on the surface, all three major western economies appear to be doing just fine.

It’s worth remembering, however, that the recession was well flagged because the central banks were telling us that it was required to rid the economy of high inflation. That is why my question this month is ‘Is a recession still required?’ rather than ‘Is a recession still likely?’ It all still boils down to a view on inflation.

I did, and still do, believe that the inflation we have experienced is not solely a cost-shock that will disappear of its own accord. It is a sign of an economy overheating, most clearly evidenced by record low unemployment and strong wage growth. This is what is feeding core inflation. And therefore, lower activity – a recession – is necessary to realign supply and demand. Put more simply, economic fragility is the necessary evil to stop companies asking for higher prices and for wage growth to slow.

Chart 4:

Could I be wrong? Could inflation magically and quickly disappear while activity remains robust and unemployment low?

There is some, albeit tentative, evidence that inflationary pressures are easing in the US. Shelter inflation could soon start to turn according to some of the data provided by property rental companies. Despite a strong jobs report and near record low unemployment, there is some evidence that wage pressures have also peaked.?

But I’m not convinced that the US is on a smooth glide path back to 2% inflation without a further weakening in activity. I’m even less convinced that inflation is under control in Europe, particularly here in the UK.

The bottom line is that we should be cautious about ever increasing equity multiples or tighter credit spreads. We’re not out of the inflation, or recession, woods just yet.

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