Reassessing Recession Risks

It often seems as if the market has a mind of its own—acting as a singular trader and pricing in new information instead of simply reflecting the consensus of millions of investors. Today’s heightened degree of uncertainty has the market confused, unable to make up “its mind” on whether the bottom is in and a new bull market is about to take hold or if there is further pain ahead. Extended indeterminacy over the speed of disinflation and its follow-on impacts on the economy—Whether increasingly higher fed funds rates will crash the consumer and the economy—are likely to leave U.S. equites range bound for at least the balance of this year. In our view, we are likely to see a shallow recession in 2023 followed by a tepid recovery, one that will nonetheless usher in a new growth cycle for stocks.

The Fed’s [brake] pedal to the metal

The Federal Reserve’s (Fed) rate-hike campaign this year has been so aggressive it has left all corners of the market reeling. For perspective on just how much the market has had to adjust its expectations for Fed policy, consider that one year ago, the fed funds rate was as low as it could go at 0–0.25%, CPI came in at 6.2% year over year (y/y), and the market was expecting one to two hikes (25 basis points, or bps, each) from the Fed in 2022. Fast forward to today, and despite the Fed implementing the equivalent of fifteen 25bps rate hikes, inflation is still 8.2% y/y. The market expects the Fed to keep going, and the Fed has confirmed as much.

In the first nine months of this year, the Fed has hiked twice as fast as the next most aggressive rate-hike cycle in history. For now, there is no more dual mandate (stable prices and full employment); there is only the goal of bringing the rate of inflation back in line with the Fed’s 2% target. This will not be easy, as price pressures have rotated from goods to services, and rent inflation (together with other home price categories makeup approximately one-third of the Consumer Price Index, or CPI) is likely to remain sticky. Encouragingly, inflation looks to have peaked, and leading indicators of inflation are all pointing in the same direction: down. For example, among the more positive signals is the ISM Services Prices Paid Index, which has historically tracked CPI quite well and is pointing to a steep deceleration in the overall level of inflation. This is what is meant by disinflation, namely prices rising but less aggressively than in the past.  In light of recent data, and as detailed below, we no longer expect inflation to slow quickly enough to avoid at least a mild recession.

Please see important disclosures at the end of the article.