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Issue 10: Weighing the Odds and Costs of a Recession

December 12, 2022

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Weighing the Odds and Costs of a Recession

Economists see a downturn on the horizon
Indeed, a recession in 2023 could be the most anticipated in history! The Federal Reserve Bank of Philadelphia surveys professional forecasters and publishes their expectations for a recession over various horizons. In their Q4 2022 survey, depicted below, the economists polled put the so-called “Anxious Index”—a measure of experts’ probability that next quarter’s GDP will decline in real terms—at over 48%. Since at least the late 1960s, when the Fed began surveying economists on the matter, a reading this high has been a sure sign of impending recession.​​​
Figure 1 Philadelphia Fed's Anxious Index

Does that square with stats on the economy today?
Recently red hot employment data and a strong service PMI show the US economy today apparently far from a massive slowdown. At the same time, core PCE inflation is running at 5%, a full three points above the Fed’s stated 2% target. Looking over the modern history of the US economy, one observes that every decline of more than 2% in US inflation precedes a recession, as does every increase in unemployment of more than 3%. In the face of this disconnect, calls for a pain-free ‘soft landing’ for the US economy seem optimistic, and we tend to agree with economic forecasters that a potentially nasty recession seems a good bet.


What’s the likely path from here to there?
As we have pointed out before, US consumers and companies have built up a strong cash cushion during the pandemic—thanks, in no small part, to generous stimulus checks and an extended period of low interest rates. Both Bank of America and JPMorgan have predicted these excess cash savings will be depleted by the second half of 2023, at which point demand will obviously suffer. At the same time, a higher cost of capital is forcing companies to pull back on capital investment and lay off workers, giving rise to a viscous cycle and, in the months ahead, as the cash cushion deteriorates, declining corporate earnings and rising unemployment.


Ultimately, the US has little choice
Based on the reasoning above, the US faces a decision: live with high inflation or pay the price of a potentially ugly recession? Not everyone gets to make such a choice. Europe was all but forced into a recession as a result of Russia’s invasion of Ukraine. China’s stringent COVID policy has dragged the economy’s growth down, despite relatively low inflation. Meanwhile, three ‘lost’ decades in Japan prove how painful long-lasting disinflation can be. Britain, for its part, has seemingly made the choice, turning from embracing inflation to accepting austerity in the unusually short span of two administrations. In a sense, the US is late to the game and yet to reckon with the brutally negative market sentiment that likely attends a sharp economic downturn.


Policy likely won’t save us
As the last two US recessions played out, authorities swiftly came to the rescue with monetary and fiscal policies. This time around, with high inflation wreaking havoc on consumers’ budgets, policymakers will be reluctant to roll out hefty QE, while a divided incumbent Congress coupled with higher borrowing costs make it even harder for the government to pass stimulus bills as they have in the good old days of the global financial crisis and COVID pandemic. In the end, businesses and households will likely need to swallow the bitter pill of recession to cure inflation—and investors may need to accept that the best returns won’t come from US stocks until the worst has passed.

High Risk, Not-So-High Return

Investors push corporate bonds higher in Q4
For the better part of past decade, with rates at record lows, investors have scrounged for yield wherever they could find it. As the outlook turned darker for equities, investors shifted their attention to corporate bonds, which only became more enticing as rates rose and yields increased. After a promising October inflation number, with traders pricing a mid-2023 peak in policy rates of roughly 5%, investors in November poured around US$16 billion into US corporate credit, sparking a year-end rally. This spike in prices for corporate bonds is reflected in narrowing credit spreads, including the spread plotted below, measuring the difference between a ‘risk-free’ Fed Funds rate, and the yield on Baa corporate bonds, which entail both duration and credit risk.

Figure 2 Moody's Seasoned Baa Corporate Bond Yield

If a recession is looming, spreads seem low
Of course, when the economy turns down, companies in a weaker financial position—including those closer to the ‘junk’ end of the credit spectrum—suffer disproportionately, in turn bringing pain to investors in their bonds. One typically sees spreads tighten over many years, as economic strength builds and investors gain confidence, then surge suddenly in the face of a crisis. The rapid narrowing of spreads in recent days, now somewhat below their historical average, along with our above comments on the likelihood of a recession in 2023, suggest to us that credit investors hold out too much hope for a soft landing and too heavily discount the risks of a rocky year ahead for corporate borrowers, particularly those on the edge of investment grade and those with longer duration (and hence greater exposure to a recession that might come in the latter half of 2023).