We should be in a recession right now. At least, that’s what pundits and economists were telling us not long ago. As recent as April, the chart below shows that the Conference Board estimated the odds of a recession starting in the next year at 99%1.
But we’re not in a recession. The economy grew 2.4% more than inflation last quarter and 2.0% in the first quarter2. Sentiment has also reversed. The Federal Reserve is now saying they don’t expect a recession this year anymore, and the University of Michigan sentiment survey just hit its highest level in nearly two years. Even the most bearish bear on Wall Street threw in the towel last week3.
Before we assess the implications of such a reversal in expectations, let’s first discuss five potential reasons why we aren’t in a recession and likely won’t see one through the end of the year.
The first reason is that rising interest rates have yet to materially impact consumers and businesses. Leading up to the Fed hiking rates, both cohorts locked in record-low interest rates for long durations. As a result, corporate interest expense, or debt relative to income, continues to fall. The chart below shows that’s never happened before during rising interest rates.
Household debt service costs are also low. The average coupon on outstanding residential mortgages is 3.5%4. Roughly 64% of mortgages have a rate below 4%, and 92% are below 6%. Savvy timing from homeowners has effectively immunized them from mortgage rates that currently reside above 7%. Credit card balances and auto delinquencies are rising but from historically low levels, and they are now back at their longer-term averages4.
The second reason is the housing market. It’s recovered quickly from the impact of rising mortgage rates due to the lowest inventory in decades. Supply has become so tight that existing homes sell for more than new homes in some markets3. Nationwide, the median home value jumped 10% in the second quarter to yet another all-time high of $350,000 after dropping 7% over the prior three quarters5.
Homes tend to be our largest asset, so the quick recovery has kept homeowners in a stronger financial position versus other rising interest rate environments.
The third reason is the deleveraging of corporations and consumers since 2008. Corporations had debt-to-equity ratios above 100% as recently as late 2019. Now that number has declined to 82%6. U.S. household debt, similarly, has come down from more than 100% of GDP in 2008 to just 76%. The amount households are paying to service debt was over 13% of disposable income in 2008; today, it’s 9.6%.
Furthermore, the portion of home equity relative to mortgage debt is the highest it's been in years5. This wealth effect has become a powerful rainy-day fund that didn’t exist back in 2007.
The fourth reason is the strength of the labor market. The U.S. continues to create more jobs, bringing the unemployment rate down to 3.5%. That’s the lowest it's been since Woodstock.
Digging deeper, the chart below shows that the labor force participation rate for ages 25 – 54, which removes the effect of the growing number of retirees, is over 83%. That’s the highest since 2002. Most people that left the workforce during the lockdowns have come back, and there are still 1.7 jobs available for every person looking7.
In fact, the single most important problem cited by small business owners right now is not poor sales, tight financing, or taxes. Instead, it’s labor quality. They can’t find enough workers to handle the demand for goods and services. Given that small businesses employ most Americans, this data point alone speaks volumes.
Most importantly, wages are up 4.4% since last year and beating inflation again for the first time in over two years. If this trend continues, it could signify the return of prosperity to Americans.
The fifth reason is that corporate earnings have been stronger than expected. Last year, companies that anticipated an economic slowdown laid off employees and shed inventory. They also reset investor expectations, and it worked.
Profit margins have mostly held up, and first-quarter earnings were 4.7% better than expected8. Roughly 85% of companies have reported second-quarter earnings, and they are 2% better than expected8. Leading indicators suggest that consumers and businesses are still spending, so it’s likely that earnings could continue to surprise to the upside through year-end.
The bottom line
Ben Bernanke famously said:
“History has demonstrated time and again the inherent resilience and recuperative powers of the American economy.”
The U.S. economy was designed to grow. There’s nowhere else in the world currently fostering entrepreneurship and innovation at this scale. It’s not even close.
For example, nearly all the advancement in Artificial Intelligence (AI) has happened here. Mega trends like AI don’t come to a screeching halt when our economy slows down or the stock market sells off, either. It didn’t last year, and comparable innovation during early 2020 kept moving along, despite lockdowns.
But the coast is not clear. We’re not back to the glory days of artificially low-interest rates and money being dumped into silly ideas that have no chance of success. Interest rates are relatively high, and that means stewards of capital will likely be more selective going forward because they can earn safer returns elsewhere.
Furthermore, the coast is by no means clear. There is a long list of economic headwinds right now, and some will worsen. But there are almost always headwinds. The question is if the tailwinds pushing the economy forward are stronger and will last longer than the headwinds.
This appears to be the case for now, but we must watch leading indicators very closely. Fed hikes tend to take a year or so to fully impact the economy, so we won’t truly understand the impact of today’s interest rate environment for a while.
Lastly, for those rare times when there appear to be no headwinds, tread lightly. These tend to signify the peak of an economic cycle after the gains in stocks have already been made. We’re nowhere close to this right now, so that means we’ll likely endure pockets of volatility that test our resolve in the coming months.
The bottom line is that we’re not in a recession, but the risk of one remains. It’s a feature of an economic recovery, not a bug, so this risk will likely stick around. Ironically, the time to worry will be that moment when it feels like that risk has gone away.
3 The Federal Reserve
4 S&P Global 2022 Annual Report
8 Bloomberg. As of 8/10/2023.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.