Time to Read: 7 Minutes
At BWM, we have said multiple times over the last year that parts of the US economy are likely already in a recession. To see examples of contraction in key areas of the economy, investors need to look no further than recent layoffs in the technology industry, a massive decline in housing starts, and a drop in consumer confidence. Plus, GDP growth has already been negative for two consecutive quarters, something that has happened in every single post-war recession. Taking these factors together, one might argue we have been in a recession for much of 2022; however, no official recession has been called by the National Bureau of Economic Research (NBER) mainly due to the stubbornly strong labor market.
The Federal Reserve (Fed) and its Chair, Jerome Powell, have two primary mandates: price stability and full employment. With the unemployment rate still very low and inflation still well above the Fed’s long-term target of 2.0% to 2.5%, investors are concerned about the Fed sending the US economy into even more pain and recession. In fact, “recession” was among the most widely searched Google keywords in 2022—and, as we begin 2023, the consensus belief is a recession is likely this year.
Here we preview part of our 2023 outlook and explore the out-of-consensus view that a softer landing may be possible as the Fed slows its pace of rate increases. While this may result in a technical recession, it could mean future market returns will be more skewed to the upside given the damage done in 2022. For the Fed to slow or stop its rate hikes, it will need to see signs that inflation has peaked and is moving towards its long-term target—and we see indications of this dynamic beginning to unfold.
Services following manufacturing into contraction
At the beginning of 2022, the war in Ukraine coupled with China’s zero COVID policy created massive supply chain shocks, sending manufacturing prices soaring as supply could not meet demand. By the end of 2022, supply chain constraints meaningfully declined as companies adapted, China eased its policy, and demand waned due to slowing economic growth. Meanwhile, services prices and growth remained sticky as consumers continued to spend down their savings accumulated during the COVID years. The most recent data, however, shows services growth has now pulled back substantially.
As shown in the lower portion of the chart below, the ISM Services PMI—an indicator that tracks US services growth—has now officially fallen into contraction territory. As demand and supply for services have become more balanced, we are seeing signs that inflation has peaked in this area and is beginning to recede.
The top portion of the chart below illustrates the steep decline in the ISM Services Price index from very lofty levels in early 2022 to a more modest range today. We think it is highly likely this trend continues into early 2023, providing signs to the Fed that sticky services inflation is moderating to more appropriate levels.
Shelter costs rolling over
Shelter is one of the largest parts of the Consumer Price Index (CPI) basket, with a relative importance of about 30%. A large portion of the shelter category is owners’ equivalent rent (OER), which is based on home owners’ estimations of how much their residence would garner in monthly rent. These shelter costs also tend to be very sticky and typically lag the Fed’s interest rate hikes. A housing shortage, low interest rates, and COVID-related issues all contributed to massive home price appreciation from 2020 into 2022—and rents and OER followed suit. Recently, we have seen some potential signs of optimism in this area.
The Fed’s interest rate hikes pushed average 30-year fixed mortgage rates to nearly 7% last year, the highest rates in almost 15 years! High mortgage rates have cooled home prices, which tend to lead and be highly correlated to rents. The chart below shows the historical relationship between home prices and rent, and illustrates the potential for future rent declines.
The chart below shows a newer index, the Zillow Rent Index, which has peaked and is beginning to roll over. While rent growth rates remain elevated, the rapid pace of decline is encouraging.
Finally, the rapid rise in single-family home prices coupled with strong rental demand in 2020-2022 dramatically increased the permits and starts of multifamily units. Unlike single-family housing starts, multifamily residences have been booming, as shown below. The share of multifamily starts relative to total starts has reached the highest level since 1973. As these multifamily units begin to come online, already-declining rents should feel further downward pressure. Since the Fed has clearly been using its rate increases to target the housing market and shelter costs, these are welcome signs of moderating pressure in a key area.
Labor market resilient, but cooling trend beginning to emerge
One area of the economy that has remained very strong is the labor market. As the top portion of the chart below illustrates, the unemployment rate of 3.46% is among the lowest levels since the 1970s, despite aggressive actions by the Fed. A full debate about the drivers of this dynamic is beyond the scope of this article; critical factors include a return to normalcy post COVID, a mismatch between job skills and available workers, and immigration policies.
The bottom section of the same chart paints a slightly different picture, showing unemployment starting to slowly rise. Some market participants, including members of BWM’s investment committee, question the Fed’s targeting of the labor market to cool inflation. Deliberately trying to put people out of work to stop prices from rising seems counterproductive on many levels. That said, a “Goldilocks” scenario—not too hot, not too cool—could be emerging for the Fed. If unemployment can remain low without wage inflation going up, then individuals won’t be able to afford certain price increases. This, in turn, reduces demand for those items and therefore prices should come down to entice people to buy those goods or services. This trend may be beginning to emerge.
The chart below shows the year-to-year change in average hourly earnings. Ignoring the COVID-related distortions of 2020 and 2021, the increases in wage growth in late 2021 into 2022 were some of the highest readings seen in more than a decade. As the Fed began its hiking cycle, the figure peaked and is now beginning to fall for all workers, as shown by the blue line. Should this trend continue without a massive rise in the unemployment rate, it could be good news for both the economy and markets.
Since you only need to open your news feed or turn on the TV to hear stories about impending doom and recession, we wanted to point out some indicators showing the possibility of a softer economic landing. While we are far from out of the woods, we believe these signs helped the market find a bottom in Q3 2022 and provide the basis for a potential recovery in 2023.
Following our objective indicators helped us reduce our exposure to equities in early 2022 then return to a slightly overweight position as markets recovered later in the year, a position we still hold today. While we remain optimistic about a soft landing, we are still advising clients to “keep their seatbelts fastened” for more potential volatility ahead. Join us for our upcoming 2023 outlook webinar where we’ll have a detailed discussion about these themes and more.