Broker Check

Could A Recession Just Be Delayed (Not Avoided)?

July 25, 2023

Put in market terms, stocks have rallied aggressively on the idea that there will not be an economic hard landing, but what if that’s premature, and the hard landing risk is still very real over the coming quarters? If that’s the case, then the longer-term risks for the market are bigger than sentiment would imply. 

And the answer is “Yes,” it’s entirely possible hard- landing risks have been delayed, not eliminated. First, the Fed has dramatically hiked rates from 0% to 5.125% and that’s impacted certain sectors of the economy such as housing and manufacturing, as they are very sensitive to the cost of capital. But it hasn’t hit the consumer yet, in part due to the massive increase in savings following the pandemic and as many consumers took advantage of low long-term rates over the past several years. Yes, rates are high, but consumers have a large-cash and low-interest buffer that is, for now, diminishing the impact of the quick increase in rates. 

How This Could Slow the Economy: 

Higher rates for longer (and higher prices for everything following the inflation spike) combined with cooling wage growth will erode this buffer (it’s happening now as we speak) and at some point, the buffer will be gone, and that’s when the true impact of higher rates will hit the consumer and increases chances for a slowdown. 

Second, real rates only recently turned positive. Core CPI was running well above fed funds until this past month. And while there are different ways to measure real interest rates, the bottom line is none of them were significantly positive until recently. This matters because interest rates are only restrictive on the economy once they are solidly higher than the prevailing inflation rate. Point being is that rates are only now truly restrictive. 

How This Could Slow the Economy: Disinflation makes higher rates more of a headwind on the economy. As inflation falls (and wage growth stalls) real rates become more positive, so disinflation will exacerbate the impact of higher rates over the coming months and quarters, increasing the chances of an economic slowdown. 

Third, unemployment remains too low to cause a slowdown. Nothing the Fed has done on the rate front has resulted in companies materially increasing layoffs, and it’s hard to get an impactful economic slowdown without a rise in unemployment. 

How This Could Slow the Economy: If disinflation compresses margins for companies (something we may see in the next two weeks, but that will become a bigger risk in Q3) and if that combines with a general slowing in consumer spending (as high interest rates bite more), then that’s a recipe for a decline in earnings that will increase the unemployment rate. 

Now, none of these risks are going to cause a near-term reversal in stocks. The “Three Pillars” of this rally remain in place: Solid economic data (hope for a soft/ no landing), Disinflation and a near-term End to Fed Rate Hikes. As long as those pillars are in place pullbacks should be shallow, and I expect cyclical stocks and value stocks (dividend stocks) and small cap stocks to catch up with the growth of large cap growth.

But if you are concerned about the economic outlook over the medium and longer term, you have justification! Markets have embraced the idea there will be no slowdown just as aggressively as they believed, at the start of the year, there would be an inevitable slowdown. And just as those predictions are too dire, the current view likely understates the risks over the coming quarters. 

Through last week, according to FactSet Research, we have seen 18 percent of the component companies in the S&P 500 post results with the overall blended earnings growth rate currently standing at -9.0 percent. This is a notable decline from the -7.1 percent that we saw this time last week and well below the -7.0 percent that was expected at the end of the second quarter. Earnings season continues to roll next week with nearly 1,000 companies reporting their results. 

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