For more than a year now, and amidst the sharpest rise in inflation and interest rates in more than four decades, investors have been on recession watch.
But lately, the data suggests that, at a minimum, the onset of recession – at least in the US – has been postponed. Recently we’ve seen upwardly revised US Q1 gross domestic product (GDP), decent income generation, initial jobless claims coming off their recent peaks and better durable goods orders. Taken together, consumers appear to be doing just fine. Looking at these numbers, you would be surprised to recall that we went through a regional banking crisis just a few months ago.
However, for those wanting to see the glass as only half-full, there are forward-looking indicators that remain troublesome.
Forward-looking indicators that suggest caution
Source: MFS Investment Mgt, Wall Street Journal
While a US recession certainly does not look imminent, monetary policy takes time to work its way through the economy. Think about businesses that sign contracts that last 1, 2 or 3 years. The US Federal Reserve (Fed) can raise rates a lot during those periods and not have an immediate impact on the economy. You might not feel the full impact of these hikes for 12 to 24 months, and perhaps that is where we are now.
Central banks rebuilding credibility
Central bankers are mindful that they lost credibility by sticking too long to a narrative that inflation was transitory, a result of pandemic-driven supply chain disruptions, and kept interest rates far too low for far too long. Looking ahead, perhaps they end up over-compensating and remain more hawkish than expected. As we know, the Reserve Bank of Australia (RBA) raised rates last Tuesday, and it might not be for the last time.
With that in mind, it is possible that the persistent strength of labour markets is incompatible with getting inflation back in its box. If the labour market remains as strong as it is now, and income generation is robust, that allows consumers to spend and keep inflation higher than it would be otherwise. So, whatever the political consequences might be, it should be the case that we will have to see a weaker labour market in order for the Fed, the RBA and other central banks to meet their inflation targets. At that point, central bankers will need to choose “the policy error of least regret”. Do they deepen a recession by maintaining restrictive policy, or do they rekindle inflation by easing too soon?
Implications for markets
For official market rates to fall materially, labour markets need to weaken substantially, inflation needs to fall more quickly, and central banks need to signal that they are done hiking. And they will need to see several months or even quarters before they are quite ready to signal that. In the meantime, it remains a case of if not “higher for longer”, then perhaps “high for longer”.
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