An economy is much like a glass of water
With the US economy expanding 2.5% in 2023 and the S&P 500 rising over 24%, many market participants believe that a recession is a distant and unlikely event. As year-on-year inflation measures continue to recede, a soft landing seems all but guaranteed. The few market commentators that hold the opposing view, that a recession is likely, are frequently required to point to some sort of a shock that would set off a recession.
In truth, no trigger is required to induce a recession. An economy is much like a glass of water. When warm water is placed in a freezer, the temperature of the water will drop linearly. Eventually the water will be cold enough that it undergoes a state transition from a liquid to a solid, in other words, from water to ice. The process in which an economy enters a recession is quite similar. A central bank will introduce tight monetary policy and at first nothing appears to change, but as the economy continues to cool it eventually freezes over. Only once this state transition has occurred, is a recession declared.
For water to turn into ice, nothing “new” has to happen, only the continuation of an existing trend. In the case of water, a steadily falling temperature, and in the case of an economy, a steadily slowing rate of GDP growth. While the cooling trend may be linear, the phase transition into ice is non-linear. Likewise, once a recession does take hold, the phase transition tends to not be linear and typically equity markets violently crash.
While one cannot pinpoint when a recession will start, it remains useful to question if the temperature of the economy is cooling, and just how close the economy may be to freezing over.
What history teaches us
When the US equity market crashed in October 1929, automobile, machinery, and steel production had already been declining for about five months – see Figure 1. In fact, when equity markets were reaching their peak in late September, vehicle output was already 30% lower. The underlying fundamentals indicating that the economy was cooling were there, investors just chose to ignore them.
Figure 1 – The economy cools before equity markets crash
A second example of this is the dotcom bust. The US Federal Reserve (“Fed”) began hiking rates to a cycle high of 6.5% in May 2000. As monetary policy was now in restrictive territory, it weakened the foundations of the continuing boom in US equity markets (much like today). The rate hikes inevitably led to the economy cooling, and the ISM manufacturing new orders index fell from 63.1 in November 1999 to 42.1 in December 2000.
The final straw was the influx of new shares being listed, typically through initial public offerings (“IPOs”). Net corporate equity issuance went from -$122 billion in 1998, to $9 billion in 1999, and to $60 billion in Q1 of 2000 alone. The equity market was unable to absorb the influx of new shares and equity markets began to tumble. The lofty tech company valuations and surge in IPOs is evidence of investors once again ignoring the underlying macroeconomic indicators and instead getting caught up in the excitement of new technologies.
Where things stand now
Many investors argue that given the strong US growth in 2023, a recession is unlikely. We certainly do not contest that the US economy has exceeded expectations, growing 2.5% for the full-year, well above economist forecasts of 1%. The second half of 2023 was even stronger, delivering 4% annualised growth, doubling the long-term US growth forecast of mainstream economists.
In addition, in the last few months of 2023 financial conditions eased, as measured by Goldman Sachs’ Financial Conditions Index (“FCI”), which is now 1.5 basis points lower than recent highs – see Figure 2. However, this is only a small reprieve. Since the lows of 2020 the FCI has tightened by more than 3 basis points, more than any other time in the four-decade history of the measure. Any other time in history that tightening has been anywhere close to this significant, a recession has followed. We would wager that this time is rarely different, and the recent easing in financial conditions is not enough to offset the significant tightening in 2022, of which, the economy is yet to feel the full brunt.
Figure 2 – Recent relief is not enough to offset 2022’s severe tightening
GDP growth may be faltering
Despite the impressive growth figures recorded over 2023, the impact of tighter rates is beginning to have an impact. Fourth-quarter growth in 2023 was one-third slower than the prior quarters 5.1%. Furthermore, relative to long term trends most of the GDP growth in 2023 was driven by government spending and not consumer spend or private investment, which both weakened further in Q4 2023 – see Figure 3. While this slowdown does not necessarily mark the immediate start of a recession, it does indicate that the expansion of US GDP may be faltering. Further evidence, that no sudden shock is required for the US economy to move from an expansion into a recession, but rather the simple continuation of an existing trend.
Figure 3 – Growth is already cooling
Delinquencies are rising too
As Figure 4 illustrates, default rates are rising meaningfully in the commercial real estate (“CRE”) office segment and have started to increase in multi-family real estate too. While the high-yield sector has witnessed the trailing 12-month default rate jump to 5.6%, up from 1.2% in February 2022. Consumers too are under pressure, as credit card and auto loans defaults rise to a higher rate than before the pandemic. In response, banks are becoming more reluctant to lend as the risk of default rises.
Figure 4 – As defaults rise banks become more reluctant to lend
The rising delinquencies are compounded by the fact that households have now largely run out of the excess savings that were built up during the pandemic. In real terms, bank deposits for the bottom 80% of households (which account for 60% of consumption) are lower than where they were at the start of 2020 – see Figure 5. Furthermore, the savings rate stood at only 3.7% in December 2023, half of what it was in 2019. Whether households like it or not, they will be forced to spend less and save more. In effect, continuing to the cooling trajectory of the US economy. This typically creates a vicious cycle of falling spend, higher unemployment, followed by even lower spending. Soon enough, the economy freezes over.
Figure 5 – Only the highest earners still hold excess savings
The Fed would probably like to cut
The Fed will want to cut rates proactively to prevent the chain reaction of events described above from unfolding. However, they know that if they cut rates too early, it could spark a second wave of inflation. The January CPI report only made this balancing act for the Fed harder. Core inflation rose 0.4% month-over-month, taking the 3-month rate to 4.0% annualised, and the 6-month rate to 3.6% annualised – see Figure 6. The same goes for both the median and trimmed-mean CPI which also ticked up. This leaves the Fed between a rock and a hard place. We believe that the Fed are unlikely to cut until they see consistent evidence that inflation has reliably cooled.
Figure 6 – January CPI inflation was hotter than expected
Investment takeaways
In our view it is clear that the pandemic stimulus delayed the onset of the recession but did not avoid it. We believe that like a glass of water in a freezer, the US economy will continue to cool until eventually its freezes over and a recession sets in. We expect that the brewing recession could emerge at some point between the middle of this year and early 2025. Given that our macroeconomic outlook appears to be somewhat contrarian, it seems quite possible that there will not be a recession until everyone else expects that there will not be a recession.
If you interested in finding out more about how cognisance of the macroeconomic backdrop helps our clients invest, connect with Integrity Asset Management and let us help you navigate your investing journey.
For more information on this synopsis or to discuss solutions provided by Integrity Asset Management, please contact us at:
Tel: (021) 671 2112
Cell: 072 513 2684 / 084 601 1025
E-mail: nic@integrityam.co.za / herman@integrityam.co.za
Source: Bloomberg, 29 February 2024