Slowing Economy for Sure - Will It Be a Soft Landing or a Recession?

Stocks advanced sharply last week (S&P 500 +6.5%), largely reversing the decline of the prior week. The rally stemmed from a technically oversold condition and some evidence that inflation might be peaking. The best performers were consumer discretionary (+8.3%) and healthcare (+8.2%); the worst performers were energy (-1.6%) and materials (+2.7%).


There is developing evidence of a cyclical slowdown. Metals prices (eg, copper) are turning lower. PMI’s are falling. China has already taken a large hit due to local policy decisions. Europe is still dealing with the impact of the Russia/Ukraine conflict. The U.S. is feeling the impact of a Fed that has turned aggressive and is aiming for restrictive monetary policy.

In responding to our mid-month SLIM Survey, the panel indicates manufacturing new orders are weakening in June. The KC Fed manufacturing survey showed backlogs easing. The U of Michigan measure of U.S. consumer sentiment, which had already registered a stunningly low reading in early June, slipped further in the final monthly reading to 50.0.

Interest-rate sensitive sectors in the U.S. (eg, housing) are starting to turn down, though not all the data has been negative (eg, new home sales up +10.7% m/m in May).

Fed Chair Powell has noted that factors beyond the Fed’s control (eg, geopolitics, supply-chain issues) will determine whether they can bring inflation down to the 2% target with the labor market still strong. We’re using the following odds for the U.S.: 50% recession, 40% soft-ish landing, and 10% upside surprise over the next 12 months. Central banks need to focus on firmly anchoring long-run inflation expectations. Until that happens, inflation data (hot) remains more important than growth data (cold).

“The world’s central banks must raise interest rates sharply, even if it significantly hurts growth, the institution known as the central banks’ central bank warned on Sunday. If they don’t, the world risks a 1970s-style inflationary spiral, the Bank for International Settlements [BIS] said in its annual report.” (WSJ)

If U.S. recession is a coin-flip in the next year (cash savings + job openings create a cushion vs. 1H weakness), the key is for inflation to peak & come down quickly. Otherwise, the year after that could see an equal chance of a downturn (the central bank will have to keep tightening, and policy acts with a lag). Flipping two coins & needing heads on both to avoid recession at the 2 year horizon doesn’t make for great odds (0.5^2 = 0.25).

Bottom line: the U.S. economy is slowing down, to rebalance demand with restricted supply & remove inflation pressure. The revision lower in the U of Michigan measure of long-run inflation expectations was welcome news last week. But measured inflation needs to come down as well.

From here (at full employment) U.S. job growth should be slowing. Cracks are developing – initial jobless claims were 229,000 again last week. Slowing corporate profit growth also argues for a reduction in business spending generally (hiring, capex, travel, advertising, etc).

As we’ve listed previously, the downside risks are: we’ve already had a surprise negative quarter in the U.S. in 1Q of 2022 (which is rare); global supply shocks are still in play (Russia/Ukraine); we’ve lost help from U.S. productivity (more pressure on supply); demand must fall to meet (restrained) supply; corporate profits should come under further pressure.

If a central bank wants to get truly tight, the short rate has to get above the inflation rate (ie, there’s a long way to go).

We compare this again to the (narrowing) path to a “soft-ish” landing: job openings > unemployed cushion; goods could cheapen with global bottlenecks clearing (bullwhip overordering); Quantitive Tightening could balance fed rate hikes; the FOMC has wiggle room around the 2% target (eg, declare victory at 2.5%); productivity could rebound due to technology.

Source: Strategas

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv.


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