Informed Tip of the Week: If you haven’t already, please take a look at last week‘s announcement about our big new hire.
Let me say upfront, I’m not saying whether I think there will or won’t be a recession. What I will say is that I find it interesting that it is near universal consensus that there will be one.
In these situations, I always think it is worth exploring the other side of the story and see how compelling it is. Given sentiment is so strong that we are likely already in a recession, if evidence emerges that we will have a soft landing, the market will be completely offsides and we could have a giant rally.
The Case For Recession
First, let’s do a short summary of the consensus view. I’m sure I will miss things. Oil prices are high which is eating into disposable income. Inflation will lead to stagflation. China’s covid shutdowns pressure global output. Some companies are now firing people so unemployment will get worse. The Fed is tightening. The yield curve is close to inverting. Mortgage rates are high.
Did I get most of them? When you plug many of these into a recession odds calculator, you tend to get an outcome of “recession > 50% likely”. It’s not unreasonable. However, it’s not at all a certainty, especially given there are some extenuating circumstances that aren’t captured well by historic models.
The Contrarian Case
So what’s the case for no recession? The pretty obvious one is that recessions are usually caused by two things: increased unemployment and decreased sales. Those things are much less likely now than in a typical recession.
Unemployment
Unemployment is historically low and there is still widespread evidence of labor shortages. While that is being counteracted somewhat by layoffs in technology and crypto, let’s be honest, Silicon Valley is not the economy. Until we see layoffs spread to industrials and retailers and hospitals, it’s unlikely we are going to see significant changes in employment levels.
Could those come later? Sure, they could, but there’s an interesting reason to think they may not. It’s some strange math around inflation.
One of the positive things about inflation (there aren’t many) is it lifts nominal results. An economy growing 3% real with 2% inflation grows 5% nominal. Also, an economy shrinking 1% in real terms with 6% inflation again grows 5% nominal.
While the latter case is, by definition, a recession, will it feel like one? If workers wages keep up with inflation in each case (a big if), most consumers don’t really feel worse off (unless you’re in one of the pockets shrinking like durable goods or producing crypto commercials).
Similarly, corporate margins won’t be pressured the same way as in a normal recession because pricing helps revenue while some costs are fixed (or semi-fixed). Therefore, there is less pressure to let workers go than when nominal earnings are shrinking.
I would argue if the unemployment rate goes from say 3.6% to 4.4% and nominal GDP grows 7% (8% inflation – 1% real) most people would find that a pretty manageable outcome rather than a justification to sell every risk asset you own.
Sales and Inventory
But, wait, if I just said real GDP will shrink 1%, isn’t that bad? The answer is it depends how it happens.
Sure, if people stop buying things, that is a bad outcome. However, there isn’t widespread evidence of that. There are pockets for sure. People have stopped buying refrigerators and furniture. They’re buying fewer units of gasoline (but more $ of it). They’re maybe trading down product quality at the grocery store.
On the other hand, there are still plenty of shortages and not all of them supply driven. There is plenty of stuff being bought. It’s just different stuff being bought than the last two years.
This is a much bigger problem for businesses than consumers. It makes it hard for businesses to plan and therefore results in more forecasting error. While consumers pay for this in the long run (through higher prices to finance the greater planning risk), in the short term, businesses have record margins and can absorb these hits.
Where this really plays out is through inventory adjustments. When inventories are building, it adds to GDP. More goods are being produced than are currently being sold and this extra production adds to GDP.
Conversely, when inventories get too high or companies anticipate slower sales, they slow production which hurts GDP. We are already seeing this happen with those durable goods that companies produced too much of before demand changed. We will likely see it spread to other areas as supply chain bottlenecks get resolved.
This process of drawing down inventories could lead to a technical recession even if end sales are still growing positively. But will it feel like one? And should the market treat a recession caused by inventory reduction the same as one caused by a decline in end user demand?
The Lack of a Credit Canary
There are certainly additional factors that could change the outlook, such as geopolitical events. One of the more obvious things to look for when a recession is coming is increased credit losses.
If consumers are really struggling, there should be increased defaults, or at least rising delinquencies. That isn’t happening yet. Corporates should be violating covenants or having scares about liquidity. That isn’t happening either. What kind of recession is this?
Recessions don’t end without credit panics. And credit panics don’t happen without warning. Now, maybe it’s too soon, but tell me where it’s coming from?
You can certainly make a case for a f/x crisis somewhere, but we lost $1T of crypto value and the financial system yawned, so can we not handle a weaker yen? Tiger Global is down 50% with no collateral damage. The NASDAQ is down 1/3 and ARKK almost 2/3 with no major casualties.
The resilience of a highly leveraged financial system to a huge change in asset values is remarkable and certainly not something I would have predicted. Isn’t that bullish?
People forget that usually true bear markets end after some big washout event that creates real fear of unknowable downside. If we can avoid a big credit scare and skate the edges of a recession, this will be the most remarkable deflating of a bubble in history.
That doesn’t mean you want to rush out to buy risk assets, but it also suggests there isn’t much of a bear story either. It could just be we kill time meandering sideways until we get to more reasonable valuations?
Assessing the Recession Odds
I think the simplest way to think about how likely a recession is may be there is a 1/3 chance of a typical recession, a 1/3 chance of no recession at all, and a 1/3 chance of a “technical” recession.
Most people look at that and say there’s a 2/3 chance of a recession. I would say it’s only a 1/3 chance with a 1/3 chance of a technical recession which won’t feel like an actual one.
The distinction is important because it suggests there is a 2/3 chance the market is headed higher (or at least sideways). For markets to head lower from here, you really have to believe a recession is highly likely and you probably have to believe there will be a credit scare for them to get them materially lower.
The latter is certainly very possible and, while I may not bet against it, I wouldn’t be betting so heavily on it either.