Last week, we argued that various methodologies point to a rising—though still moderate—probability of a short-term recession in the U.S. ( https://www.fynsa.cl/newsletter/evaluando-los-riesgos-de-recesion-en-ee-uu/), but that high inflation is forcing the Fed to abandon its countercyclical policy, which could effectively lead to a recession, and that it is now less likely that “the Fed will eventually save the market,” since, if the Fed is determined to bring inflation down to its target, it is likely to cause significant economic pain first.

In this regard, the latest data continue to point to a sharp slowdown, and negative economic surprises have increased. What’s more, judging by the Atlanta Federal Reserve’s GDP estimates for Q2 2022, the U.S. economy may already be in a recession, as its latest update points to a 1.0% contraction in GDP—on top of the already revised official figures for Q1 2022, which showed a 1.6% contraction.

Market prices, meanwhile, are also beginning to reflect a growing risk of recession. In addition to the more than 20% decline in equities from their January highs, there has been a sharp correction in commodities (copper prices, for example, have fallen nearly 20% in the last 4 weeks), and U.S. Treasury yields have already fallen more than 50 basis points from their mid-June highs (the 10-year Treasury yield is back below 3.0%), and expectations for the federal funds rate now factor in nearly three rate cuts for 2023 (from the 3.5% it is projected to reach by December of this year—a level that, given current developments, may not be reached).

But if there were indeed a recession, what would it be like?

• This recession would be driven by inflation, not by credit, and it would most likely be less severe than the previous three for several reasons: the absence of credit bubbles; strong balance sheets for companies, banks, and households; a robust labor market; and low inventories in vulnerable industries such as housing and automobiles, as noted in a recent Morgan Stanley report.
• The pandemic-induced shutdown of 2020 is obviously unique. The recessions that followed the 2007–2008 financial crisis and the 2000–2001 dot-com crash were credit-driven. The result was excessive construction of housing and Internet infrastructure. In both cases, it took nearly a decade to absorb the excesses, and the implications for corporate earnings were disastrous. S&P 500 earnings fell 57% in 2007–2008 and 32% in 2000–2001.

• Fundamentally, the excesses of the current cycle are not driven by credit, as the balance sheets of corporations, banks, and households are the strongest they have been in decades. Rather, the excesses of the current cycle have been driven by liquidity, which fueled speculation in financial assets such as cryptocurrencies, venture capital, unprofitable tech companies, and special purpose acquisition companies (SPACs). Unwinding those excesses has so far caused little harm to the economy.
• And what about inflation-driven recessions? As we also noted last week, we don’t believe that the analogies from the 1970s and 1980s apply now, even though inflation is at a 42-year high. The recession that began in 1973 and lasted until October 1974 (with the S&P 500 falling by -48%), took place during a period of inflation that lasted a couple of years (oil prices, for example, quadrupled), when inflation even exceeded double digits—just as it did in the early 1980s (the economy had just weathered two oil shocks, in ’73 and ’79), leading the Federal Reserve Board, headed by Volcker, to raise the federal funds rate—which had averaged 11.2% in 1979—to a peak of 20% in June 1981.

What we have today, however, is that while most survey-based measures of inflation remain at multi-decade highs, market-based readings do not indicate a further unanchoring of inflation. In fact, they have even moderated considerably recently. Ten-year inflation breakevens have returned to 2.3%, within their range of 1.5% to 2.5% over the past two decades. If they fall to 2% or below, the Fed will likely soften its tone and slow the pace of rate hikes.

All in all, recent developments do not significantly alter our conclusions: that the markets—and equities in particular—already largely price in an “average recession,” and that the market’s potential bottom may not be that far from the lows already reached. Of course, volatility will persist for some time, and there is a risk that corporate earnings expectations will be “revised downward,” since it is inconsistent—given the growing risks of a recession—for the market to continue pricing in around 10% growth in corporate earnings for this year. Nor should you expect corporate earnings to suffer a major collapse, since—as is generally the case during periods of inflation— “nominal prices cushion the weakness in real volume.”

Humberto Mora

Investment, Finance, and Business Manager; Stockbroker