USA: Still on track for recession?

The US economy grew by a lacklustre 1.1% annualised in the first quarter, and while we currently expect an even weaker outcome in the second quarter, there is not much sign at present that the recession has already begun.

The recent wave of US bank failures and continued stress in some regional banks could have been a catalyst to jump to recession, but we don’t see a lack of continuity in the data. Bank lending data is trending down but not collapsing and the labour market has remained resilient. Services PMI (purchasing managers’ index) readings have held up well, but other measures of confidence appear fragile. In particular, future capex intentions now look very depressed across a number of surveys.

While we will continue to monitor the high frequency and confidence data, we are conscious these can get buffeted around alongside swings in sentiment and financial markets. As macro investors, we want to avoid chasing the price action in our economic forecasts even though we believe models using financial market variables to forecast GDP work reasonably well. Instead, we remain grounded by our fundamental assessment of where we are in the business cycle. The data behind this assessment are captured in our recession indicators heatmap, and tend to be slower moving and less influenced by current market dynamics.

Recession signal

While the heatmap should not be used as a precise timing tool, the message is clear. Recession is a strong base case outlook within the next few quarters and potentially imminent.

Overheating

Inflation well above target, strong wage growth and historically low unemployment are also reflected in the positive output gap, which together at a minimum suggests that we are at a very late stage of the economic cycle. Household saving rates look unsustainably low and the stock of excess saving from the pandemic has been run down rapidly.

But we also have other warning signs.

Lagged impact of monetary tightening

The US Federal Reserve (Fed) now seems set to pause rate hikes, but its aggressive tightening campaign is starting to have an impact, both on rising debt servicing costs and lending standards, which continue to tighten. This is leading to slower credit growth.

While the Senior Loan Officer survey was perhaps not as bad as some feared, it is as tight at the early 1990s recession. Favourable comparisons with the extremes of the financial crisis and the pandemic should not lead to comfort that recession can be avoided. We expect lending standards to remain tight all year as banks suffer deposit outflows from ongoing quantitative tightening and more attractive returns in money market funds.

Profit margins are now under pressure and as demand weakens and inflation cools, we expect the earnings squeeze to intensify and for firms to look for ways to cut costs. As the labour market turns this will amplify the consumer slowdown as incomes slow further.

Path to eventual recovery

Exactly how this potential recession unfolds remains to be seen. We can’t rule out further financial accidents which could amplify the downturn. The debt ceiling could lead to turmoil or at least highlight the lack of fiscal space to offset shocks. Commercial real estate appears vulnerable, not to mention the opaque world of leveraged loans, private credit and equity.

We are looking for a peak-to-trough decline in output of around 1.5%, but there is a wide range around this. The deeper the drop, the quicker the inflation will be wrung out the system and the faster the Fed can cut rates. This could lead to a resetting of the cycle and a more rapid recovery on the other side.

Conversely, a mild recession might not create much slack, and while our recession indicators would surely improve, they might not turn sufficiently green to signal a long and durable expansion ahead.