Six potential reasons why this time is different, and there won't be a recession
I collected the six most commonly mentioned reasons why we don't get a recession and scrutinized their validity.
Welcome to another episode of The Market Routine - your expert guide to navigating the ever-evolving financial markets.
A Big Recession Poll
According to Macrobond, 100% of the yield curve is now inverted. Even though the 30-year Treasury yield is a couple of basis points higher than the 10-year Treasury yield, the message of the chart is clear: the yield curve is signaling a US recession is in the making.
I conducted an open poll on LinkedIn and Twitter, which went viral, asking for ‘the best reason why this time will be different, and there won’t be a recession.’
Apart from the ‘basic’ responses suggesting everything is a conspiracy and all data is false, The most frequently mentioned reasons were:
- Inflation is over, and the Fed will lower yields
- A strong labor market resulting in robust wage growth and consumer spending
- The recession has already taken place, but conventional indicators did not indicate it
- The recession is a massive consensus
- The China reopening
- No reason, there will be a recession
In this episode of The Market Routine, I will take a closer look at each of these most-common reasons why this time will be different.
Reason I - Inflation is over, AND the Fed will lower yields
The ‘AND’ is important here as this reason why a recession will be averted depends on two crucial factors. First, at this stage, can there be any true conviction at the Fed that inflation has been defeated? Despite the efforts to curb inflation, it continues to persist in several wage-intensive service industries such as education, healthcare, retail, and others. The stark difference between the ISM Manufacturing and Services Price indices is evidence of this persistent inflationary pressure.
Second, given the above, I’m struggling with the incentive the Federal Reserve may have to lower yields to prevent a recession.
If markets are right, and the Fed cuts rates in November, the terminal rate would only be kept steady for roughly six months, which is shorter than the average(median) holding period following previous tightening cycles. Why would FOMC members, who were entirely wrong on the way up, decide to start cutting rates earlier than usual after just witnessing the higher inflation levels in 40 years? For this scenario to materialize, a sharp decline in inflationary risks across all sectors of the US economy is necessary in a matter of months.
In conclusion, the notion that a US recession will be averted solely due to the Fed cutting yields is not a plausible scenario to me.
Reason II - The labor market is strong
Despite the favorable labor market conditions and wage growth in the US, this is not a guarantee to prevent another recession.
Although inflation has decreased, real wage growth has been negative for 21 months in a row.
Additionally, the savings ratio has dropped to historical lows, and the Covid-related government transfers have been exhausted for a majority of low and middle-income households.
In addition, the latest US GDP Growth report confirmed that final demand from consumers is fading. Check out the black bar in the chart below showing the ‘growth’ in final sales to private domestic purchasers.
With the Fed really wanting to see a softer US labor market, meaning unemployment must rise, the odds of a consumer spending stop remain high. If spending accelerates again, this will result in a premature rise in inflationary pressures.
Reason III - The China Reopening
China has recently lifted most of its COVID-19 containment measures, opening the door for the country to regain its lost GDP growth. The chart below, displaying the Manufacturing PMIs in the US, Eurozone, and China, shows the extent of growth momentum lost due to ongoing COVID restrictions. The US and the Eurozone saw their PMIs rise above 60 after massive fiscal and monetary stimulus and easing of lockdown and quarantine measures, while China’s Manufacturing PMI remained at or below 50.
The direct impact of China’s reopening on the US economy should not be overestimated. The US exported a total of USD 151 billion to China in 2021, representing only 8% of its total exports of USD 1.8 trillion, as shown in the chart from Visual Capitalist. US-China trade is heavily skewed toward imports, which totaled USD 506 billion in 2021, or 17% of all imports of USD 2.9 trillion.
Total trade (the sum of exports and imports) accounts for just over 20% of US GDP. Despite a rising trade deficit, on average, total trade has only slightly reduced quarterly reported GDP growth by 0.18% (annualized). Hence, China’s exports, with their modest share in total trade, have a limited impact on overall US GDP growth numbers. Even if the USD 2 trillion of pent-up savings of Chinese consumers double the amount of US exports to China, it would still have a minor impact on the overall economy.
The reopening’s total impact on the global economy is what truly matters. If it helps prevent Germany from entering a recession, for example, positive ripple effects will reach the US economy. Furthermore, if the reopening is accompanied by a substantial increase in China’s credit impulse (change in credit growth relative to GDP), it will provide a boost for financial markets, improving financial conditions. I believe that China has some potential, both directly and indirectly, to positively impact US GDP growth, which theoretically may mean the difference between a recession or not.
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