Partly Cloudy With a Chance of Recession

Major stock market indexes opened sharply higher this morning, extending the nearly month-long rally. The Dow is up nearly 500 points and the S&P 500 is up 1.2% in early trading. It seems likely this little rally is owed in part to midterm elections, which are expected to yield gridlock in Washington. In addition, we’re finally seeing some weakness in the dollar, which serves as a tailwind to stocks and commodities. A stalling dollar may also suggest that we’ve reached peak interest rate expectations (and peak Fed hawkishness). That’s the hope anyway. Bonds are rallying today: long-term Treasuries +1.3%; intermediate high-quality corporates +.6%; junk corporates +.2%.

Recession speculation is rampant. A recent Bloomberg survey of economists set the odds of an economic recession at 60%. The Conference Board predicts a 96% likelihood of recession within the next 12 months. Goldman Sachs, however, believes it is closer to 35%. That’s still twice the normal risk, but the firm’s chief economist Jan Hatzius sees a “very plausible” scenario in which we avoid recession altogether.

He says the economy has already transitioned from high to anemic growth, mostly because the Fed is raising interest rates in order to bring down inflation. But this new phase need not result in a big downturn, as long as we start seeing signs of slowing wage growth, easing inflation, and a better balance between supply and demand for labor. Indeed, wage growth is beginning to slow. The Bureau of Labor Statistics says average hourly earnings growth has slowed to 4.7% from 5.6% last March. Mr. Hatzius cites evidence of lower inflation—used car prices, rent on new leases, transportation costs. But I think it’s fair to say we just haven’t seen enough progress on inflation yet. The big fear is that it will remain “sticky,” forcing the Fed to continue raising rates until it “breaks something.”

Why would Goldman dare to be cautiously optimistic? Two words: balance sheets, unemployment. Consumers and businesses remain unusually stable, financially speaking. Bank CEOs tell us the average consumer has more cash on deposit than before Covid hit. The average household has $7,500 in credit card debt vs. $8,500 at the end of 2019. And household debt service as a percent of disposable income is 9.6% vs. 9.9%. In addition, the Fed tells us “interest coverage ratios for large businesses reached historically high levels” this month. In other words, servicing debt is no problem. Next, it’s very difficult to enter a “recession”—as defined by the Nat’l Bureau of Economic Research (NBER)—when unemployment is at 3.7% and there are nearly 2 open job positions for every unemployed person. This is exactly why NBER didn’t announce a recession earlier this year when we had two consecutive quarters in which the economy contracted. My point is that things need to get a whole lot worse before we can really start talking about recession as a likelihood.