Thesis Summary
The Federal Reserve has decided to keep rates unchanged, but most agree that cuts are coming later this year.
All this, as we begin to see early signs that the US economy is slowing down. Powell has been clear that they are happy to cut as soon as they see weakness.
But can the Fed actually avoid a recession?
History suggests there’s little the Central Bank can do to aid the real economy once the deleveraging cycle starts.
With that said, the Fed can contribute towards keeping markets higher for longer.
Early Signs Of Recession
The economy is beginning to weaken, and there’s plenty of macro data supporting this.
The US unemployment rate has now climbed up to 4.0%, increasing for the third month in a row.
The weakness in the labor market can also be appreciated if we look at total quits.
Employees are clearly a lot less comfortable leaving their jobs with fewer good opportunities out there.
On top of employment, we are also getting some clear signs from credit markets, often a tell-tale sign that something is not quite right.
As we can see in the image above, the spread between the lower grade ML CCC and the ML B bonds is beginning to increase. We saw this exact thing happen back in 2019, just ahead of the COVID market crash.
The consumer is now beginning to feel the squeeze of credit to a much larger extent.
For starters, excess pandemic savings have now been depleted.
The huge cash buffer that was made available following COVID is no longer there, and this comes at a time when debt service ratios are back above 15%, and this was in Q2 of 2023.
The debt service ratio reflects what percentage of income consumers need to pay off their debt. Back in 2007, this peaked at around 18.3%, Again, thanks to the pandemic stimulus, the ratio was near all-time lows, but has been creeping up in the last two years.
And, lastly, we can see that Real GDP is beginning to turn down again. We have seen weakness in GDP numbers and numerous downwards revisions. The economy is no longer as strong as it was.
Can The Fed Stop A Recession?
This time around, like many other times, it seems like plenty of investors are confident that the Fed can achieve a soft-landing.
Is this realistic?
The above research from IWM financial lays out the previous tightening cycles, and whether a soft or hard landing was achieved, though this can be somewhat contended. On the chart above, we can see interest rates and inflation plotted against each other.
In more recent history, 1995 was clearly an instance where a soft landing was achieved, and not unlike to today’s situation.
Inflation was running at 3% and unemployment was close to 6%. The Fed tightened in 1995 and a soft landing was achieved. Markets roared throughout the 1990s on the back of the new age of the Internet narrative. Again, not unlike today’s AI-driven rally.
In 2000, we, of course, had a huge market crash, but the author of this research classifies this as a “soft landing”
Was that a hard landing? Not very. The two (nonconsecutive) quarters of negative GDP growth in 2001 were so small that they left GDP for the year as a whole higher than in 2000. For that reason, I have long called it the “recessionette.” Regardless of terminology, the landing was on the soft side.
Interestingly, while we could argue that a soft landing was achieved in 2000, we also saw a huge market crash due to inflated stock market valuations.
Then we got hard landings in 2007 and 2019, but of course, we have to realize that there are tons of other factors coming into play here.
What does this mean for markets?
Ultimately, though, the “pragmatic investor” worries about a recession only to the extent that it can affect markets.
With the Federal Reserve arguably very close to a rate cut, what does history tell us in that regard?
In three out of the last five instances, the first rate cut has been followed by 12 months of positive, and well above-average returns. In 2001 and 2007, we saw above-average losses.
Statistically, the average return is 2.34% after 12 months, but this, of course, is very unreflective of the actual reality.
Either a soft landing is achieved, and the markets welcome the rate cuts, or the rate cuts simply precede a large degree of recession and/or market sell-off.
There are no doubt plenty of other factors at play here, and we should be careful not to oversimplify or confuse coincidence and causality.
Markets are driven by fundamentals and valuations, and these are different at every point in history. Every recession takes a different form, and often takes a different response.
A final chart to close out this section and perhaps put things into perspective.
The percentage of stocks outperforming the S&P 500 Index (SP500, SPX) is at record lows. Only during the 1999 dot-com bubble did we see this kind of behavior.
Takeaway
All in all, here are the main takeaways from this article.
Recessions are difficult to predict and time
The Fed does not control everything
Recessions and market crashes aren’t the same.
Despite clear data suggesting the economy is weakening, there’s no clear way to know with absolute certainty what is going to happen. As macro analysts, we can follow certain metrics and indicators, but many of these are lagging, and can never account for black swan events.
Economics is a complex subject. Recessions have many components and possible explanations and triggers. Yes, the Fed certainly has some power in controlling expectations, but I would not put too much stock in what the Fed says or does in terms of “practical” investment advice, though it can certainly be helpful.
Recessions and crashes can vary in their severity. Markets can crash heavily even without too much economic weakness, as in 2000. Or, they can also reach new highs while economies are essentially shut down, as it happened during COVID.
As investors, the best way forward is to clearly understand what our objectives, timeline and expectations are.