Last week we argued that different methodologies show an increasing, but still moderate, probability of a near-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 counter-cyclical policy, which could effectively end in a recession and that today it is less likely that the "Fed will eventually save the market", since, if the Fed is determined to bring inflation down to target, they are likely to cause a lot of economic pain first.

In this sense, new incoming data continue to show a marked slowdown and negative economic surprises have increased. Even more: judging by the Atlanta Federal Reserve's 2Q22 GDP estimates, the US economy could already be in recession, as its latest update points to a 1.0% GDP contraction, which adds to the already revised official figures for 1Q22, which showed a contraction of 1.6%.

Market prices, meanwhile, are also beginning to incorporate a growing risk of recession. The more than 20% drop in equities from their January highs has been compounded by a sharp adjustment in commodities, (copper prices, for example, have fallen almost 20% in the last 4 weeks) and US treasury interest rates have already retreated more than 50 basis points from their mid-June highs (the 10-year treasury is back below 3,0%) and fed funds rate expectations already incorporate virtually 3 rate cuts by 2023 (from the 3.5% it would reach by December of this year, which as things are evolving, may not be reached).

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

• This recession would be inflation-driven, not credit-driven, and would most likely be shallower than the previous three for several reasons: the lack of credit bubbles; strong corporate, bank, and household balance sheets; a strong labor market; and low inventories in vulnerable industries such as housing and autos, as noted in a recent Morgan Stanley report.
• The pandemic-induced shutdown of 2020 is obviously unique. The recessions that emerged from the 2007-2008 financial crisis and the 2000-2001 dotcom crisis were credit-driven. The result was overbuilding of housing and Internet infrastructure. In both cases, it took nearly a decade to absorb the excesses and the implications on 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 credit-driven, as corporate, bank and household balance sheets 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 technology companies and special purpose acquisition companies (SPACs). Unwinding those excesses so far has not caused much damage to the economy.
• What about inflation-driven recessions? As we also got last week, we don't think the analogies from the 1970s and 1980s apply now even though inflation is at a 42-year high. The recession that started in 1973 and lasted until October 1974 (with the S&P 500 dropping -48%), was framed by an inflationary period of a couple of years (oil prices for example quadrupled), where inflation even exceeded 2 digits, as in the early 1980s (the economy was coming off 2 oil shocks, '73 and '79) and which led the Federal Reserve Board, led by Volcker, to raise federal funds interest rates, which had averaged 11.2% in 1979, to a high of 20% in June 1981.

What we have today, meanwhile, is that while most survey-based measures of inflation remain at multi-decade highs, market-based readings do not account for further inflationary de-anchoring..... Moreover, recently, they have even moderated quite a bit. Ten-year inflation breakevens have returned to 2.3%, within their 1.5% to 2.5% range of the past two decades. If it falls 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 greatly change our conclusions: that the markets, and in particular equities, already largely price in an "average recession" and that the potential market bottom would not be that far off the lows already realized. Of course, volatility will persist for a while, and there is a risk of "candor" in corporate earnings expectations, as it is not consistent, given rising recession risks, for the market to continue to incorporate around 10% corporate earnings growth for this year. Also, do not expect corporate earnings to suffer a large plunge, since as is generally the case in inflationary periods, "nominal prices cushion real volume weakness".

Humberto Mora

Assistant Investment Manager Finance and Business Finance and Business Brokerage Firm