Six reasons why a recession might be unavoidable Six reasons why a recession might be unavoidable\images\insights\article\headwinds-dark-small.jpg April 28 2023 February 15 2023

Six reasons why a recession might be unavoidable

The economy is facing stronger headwinds than the markets realize.

Published February 15 2023
My Content

That the financial markets and the Federal Reserve aren’t seeing eye-to-eye about the direction of monetary policy should be a moot point—only one has its hands on the wheel. The recent rally in risk assets seems like wishful thinking in the face of the Fed’s determination to slay inflation. Here are six reasons why we think the economy is headed into a recession later this year, despite the resilience of the labor market, and why we think a conservative approach is warranted.

No. 1:  Money supply is shrinking Ample liquidity is critical for the health of the economy, one of the reasons the stock and bond markets love accommodative policy. Weak growth of the money supply would be bad news, but liquidity is now actively draining from the system. The last time it declined on a sustained basis was during the Great Depression. 

No. 2: That other tightening tool Lost in the fervor over hikes is the continuing reduction of the Fed’s balance sheet, which has a much bigger impact than the markets realize. The San Francisco Fed estimates that the impact of the $95 billion monthly roll-off suggests the economy is actually facing a fed funds rate over 6% rather than 4.5–4.75%. If that’s true, real interest rates across the entire Treasury curve are deeply negative and a significant drag on the economy.

No. 3: LEI is DOA It's not that bad, but the Index of Leading Economic Indicators has fallen for 10 consecutive months. With its components measuring many aspects of the economy, a decline in this broad metric is a strong clue that a recession is coming.

No. 4: Follow the line Sometimes it’s best to keep it simple. The Treasury yield curve remains inverted—perhaps the most reliable predictor of a recession.

No. 5: Declined! Banks have brought back the infamous trope of a loan officer informing a couple across a large desk that he’s turned down their loan application. It’s not exactly that bad, but since the 1960s, banks have tightened consumer credit on only nine occasions and a recession has followed in eight of them.

No. 6: Earning their keep Since 1950, every recession has been preceded by a significant correction in corporate profit margins. That hasn’t happened yet, but most of last year’s revenue came not from increased sales volume but from companies raising prices. That will be harder to repeat as inflation pressures fade. Also, profit margins are getting squeezed between falling pricing power and sticky wages.  Further, operating cash flow for S&P 500 companies in the aggregate is running 15% below reported earnings. That’s pretty rare, and usually an indicator earnings will fall.

Tags Markets/Economy . Fixed Income . Interest Rates . Monetary Policy . Inflation .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

The Conference Board's Composite Index of Leading Economic Indicators is published monthly and is used to predict the direction of the economy's movements in the months to come.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Stocks are subject to risks and fluctuate in value.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Federated Investment Management Company