Where’s the Recession?

03.08.2023 “Animal spirits” sounds like something one might find on the cocktail list at a posh safari lodge. However, the term was coined by John Maynard Keynes in his 1936 book “The General Theory of Employment, Interest and Money” to describe the emotions and behaviors that influence economic activity. Since then, the financial community has devised myriad methods of calibrating the moods of consumers, business decision makers and investors to get a bead on economic headwinds and tailwinds. Such measures are particularly relevant today as we wait for the full impact of higher interest rates on economic growth and corporate profits. We could be waiting a long time for the answers: history suggests the lag could be between 18 months and two years.

Consumer confidence is one of the most important factors in estimating retail spending, which accounts for about two-thirds of US economic activity. Here, the news is dour, thanks to high food and energy prices. Consumer confidence in February was weighed down by lower expectations for factors including future business conditions and job availability. The deterioration of confidence would have been even worse if not for today’s tight labor market. If the close relationship between confidence and spending continues to hold, we should expect weaker sales growth in the coming months.

National Federation of Independent Business (NFIB) surveys track the state of the economy through the eyes of small business owners. The NFIB Optimism Index, which measures a variety of views of the future, currently hovers around its lowest level in a decade – lower than the pandemic low and consistent with recession.

The share of small businesses raising prices in January fell to its lowest level since May 2021, according to the NFIB survey released last month. That’s consistent with the pullback we’re witnessing in inflation readings. The survey also showed that 29 per cent of small business owners plan to raise prices in the next three months, reversing a downtrend that has been in place since last October.

Business spending is expected to fall as capital expenditure plans cascade toward COVID-lockdown levels. We’ve already heard from Microsoft, AMD and Intel that the PC replacement cycle is dead, with employers now busy lightening their labor ranks as they anticipate slower conditions.

Sour sentiment enveloping Main Street has spilled over onto Wall Street. The Treasury yield curve, which has accurately predicted our last seven recessions, is warning of recession again. Whenever the 10-year yield has fallen below that of the 2-year note, a recession has ensued. Recently, the yield differential between the 10-year and 2-year notes has fallen to negative one percentage point, its widest spread in 40 years.

So, we have lugubrious sentiment and dramatic yield curve inversion – but where’s the recession? History has shown it takes between 18 months and two years for economic fundamentals to reflect higher interest rates. The time lag between the peaks in Fed Funds and unemployment claims can stretch out nearly three years. Meanwhile, the Fed’s current strategy of ratcheting up short-term rates in response to last month’s economic data appears short sighted. This reactionary approach doesn’t take the delayed impact of monetary policy into consideration. It’s as if Jay Powell is riding a bicycle while looking down at his pedals, when history suggests he should be peering well over his handlebars. The Chairman has articulated that the Federal Open Market Committee would rather err on the side of tightening rather than run the risk of letting the inflation genie fully escape from the bottle. We believe monetary policymakers should trust the historical record.