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Economic activity: No natural gas shortage in Europe and an overheating job market in the USA – has the recession been called off?

Kaiser Partner Privatbank: Electricity and natural gas prices have fallen, peak inflation is in the rearview mirror, and the “reopening” of China’s economy promises to give a boost to growth in the quarters ahead. This has banished the specter of a recession in Europe. After hitting bottom last autumn, business (and consumer) sentiment has since improved significantly (or at least has found a floor). More and more economists are scrapping their recession forecasts and raising their growth projections for 2023. GDP growth data for the Eurozone for the fourth quarter of 2022 already came in better than expected with a mini-uptick of 0.1%. Only Germany saw a surprising downward revision for the final quarter of last year and might actually experience a “technical” recession this winter.

So, of course, one cannot simply draw the curtain over the recession question. It continues to be a valid one for the US economy and remains a perplexing mystery for the analyst community because established macro indicators like the US yield curve and the Conference Board’s leading indicators index continue to signal a heightened risk of a recession. Announcements of mass layoffs, particularly at big tech firms and in the financial sector, appear to fit with this picture. But it is con- tradicted by very robust US labor market data (which are prone to undergo substantial revisions, though): 514,000 new jobs were created in January while the US unemployment rate fell to a 54-year low (3.4%). The number of job openings recently resumed rising while initial unemployment claims decreased. This conflicting set of data is also reflected in the recession projections in the Wall Street Journal forecaster survey. In the latest survey, the expected probability of a recession within the next 12 months ranged widely from 10% to 100%, but the median projection stood at a relatively high 65%, which means that the consensus does not believe in a soft landing.

We, however, tend to side with the optimists. Our expectation expressed in our outlook for 2023 remains intact: a recession looms in the USA probably later than the majority is anticipating and is likely to turn out relatively mild. A recession most likely is unavoidable in the end because the many uncertainties and numerous variables (and a poor track record) make it too hard for the US Federal Reserve to keep on finely recalibrating its monetary policy, but it will take some more time before a recession arrives. There are currently 1.9 job openings for every unemployed person in the USA, and almost every industry is reporting more vacancies than usual. Anyone who was laid off recently and/or is currently looking for work will probably find a new job in the quarters ahead with relative ease. Moreover, US households are still sitting on USD 1.4 trillion of excess savings from the pandemic. Based on the current personal saving rate, it would take 15 months to completely use up those savings. The US consumer-spending engine therefore won’t start to sputter so quickly. However, in mid-2024, the probability of a recession is bound to surge because the knock-on effects of the Fed’s ratehiking cycle should become increasingly palpable then. Moreover, a scenario in which the current phase of disinflation is followed by a second wave of inflation cannot be ruled out. The reopening of China’s economy could exert an inflationary impact, as could a future return to rising real wages (thanks to the current pullback in inflation). The Fed would then be forced to keep interest rates at a very restrictive level for a longer time. This scenario would automatically result in a sharper rise in unemployment and a recession.

Monetary policy: Fixed-income market participants are speculating that the US policy rate will pull back soon. Isn’t the proverb “Don’t Fight the Fed”?

Kaiser Partner Privatbank: The US Federal Reserve and the financial market were long in disagreement. Financial market participants specifically were anticipating that the Fed would revert to cutting interest rates by as early as the second half of this year either because inflation will recede very quickly in the months ahead or because the USA will soon slip into a recession. But the very robust January employment market data and the slower-than-hoped-for subsiding of inflation recently prompted them to change their thinking. So, have they decided not to fight the Fed after all? Fed officials’ dot plot sees the federal funds rate at 5.1% at the end of 2023 (median estimate). Current trading in federal funds futures contracts indicates that financial market participants now likewise see the policy rate at 5.1% in December, but they expect it first to climb much higher than that level this summer. The market prices basically imply that the interest-rate level temporarily will (needlessly) be raised too high and that the Fed will thus make a monetary policy mistake. There is also agreement that interest rates will soon start to fall again and that the current level is already well in restrictive territory. The Fed’s median projection sees the US policy rate at just 4.1% at the end of 2024 while the financial market’s expectation is situated not far from that forecast estimate.

So, the financial market is not necessarily positioned against the Fed and its monetary policy anymore. Investors should position themselves the same way because the best way right now to interpret the motto “Don’t Fight the Fed” is as follows: The Fed is still in the middle of a ratehiking cycle, and the stock-market rally in recent weeks has been thwarting its efforts to make the monetary environment more restrictive. In fact, various financial conditions indices have recently been showing a substantial easing. Investors should contemplate doing at least some profittaking because the already small probability of a soft landing by the US economy won’t come true unless the Fed immediately reverses course. But that’s not the Fed’s plan. If interest-rate cuts do come sooner or later, they too wouldn’t necessarily be a reason for investor euphoria because if a recession actually turns out to be the cause of falling policy rates in the future, a dip to new share-price lows likely lies ahead on equity markets.

Headed backwards soon? | The financial markets expect the Fed to reverse course soon (Implicit) expected change in federal funds rate, in basis points

Sources: Bloomberg, Kaiser Partner Privatbank