US Economy and Market Cycles

Price of reigning in inflation is a recession, which seems to be the only way out today. But the question is by when, and how deep? And how to think about financial market outcomes in such times.

6 coincident activity measures used by the NBER’s Business Cycle Committee to declare recession in the US points to a likely recession in the US by 3Q 2023 or latest by 4Q.

Leading indicators point to a significant downturn in the US manufacturing and residential investment sector resulting in a fall in US imports and new orders. US job market is holding strong for now despite multiple anecdotes of layoffs.

During inflationary periods, it's not unusual for employment downturns to begin months, after the start of recession. We saw that in 1973-75 and 1980 recession. Higher inflation leads to a delayed onset of profitability loss, which in turn delays the layoffs. Presently, corporate profit will act as a leading indicator of wage growth and inflation moderation.

1973 and 1980 recession saw rate hikes owing to higher inflation and strength in job market data. Given that inflation, corporate profits and job market data rhymes closer to the decades of 1970s-80s, market has been consistently trumped in pre-empting rate cuts.

Synchronized and aggressive rate hikes thus far make a case for deeper problems in real economy ahead. The aggressive rate hikes of 1980s to single-mindedly tame down inflation was also made possible due to contained leverage in the system. Things are quite different today with government debt to GDP ~110% (vs. ~35% during 1980s). Consequently, even as the US Fed wants to retain its inflation fighting credibility, the issue of financial stability (emanating from high leverage) will make it harder going ahead.

Aggressive tightening thus far and concerns on financial stability implies slower growth going ahead and then key is to figure out how does market behave during growth corrections. Equity market starts to correct prior to recession onset but bottoms out even as we are into the recession. During 1973, 2001 and 2008 recession, S&P fell by ~50%. On other occasions, there has been ~20% corrections (1981, 1990 and 2020 recession). Currently, S&P has fallen 17% from its peak.

The template for fixed income assets were very different during 1970s-80s, compared to last three decades when duration assets start to perform at mature stage of rate cycle.

2022 was one of the worst years for combined returns of stocks and bonds market in the US. In 2023, equity market prospects is still grim unless we see a significant dovish tilt by the US Fed and greater clarity on depth and breadth of recession. Outlook for duration assets is improving at the margin. That said, longevity of duration rally can be challenged unless inflation is brought under complete control.

Almost since the start of Fed tightening in the first quarter of 2022, the most frequently asked question about the global economy has been whether the FOMC’s fight to tame inflation inevitably means the US economy is heading for recession. Price of reigning in inflation is a recession, which seems to be the only way out today. But the question is by when, and how deep? And how to think about financial market outcomes in such times.

Dating committee referred data hints at US recession by end 2023.

The US has seen 12 recessions post World War with 2008 GFC being the longest and 2020 COVID being the shortest (Chart 1). The country has a separate organization, National Bureau of Economic Research (NBER) which declares recession and it may not necessarily coincide with the technical definition of recession. NBER determines recession based on six coincident monthly indicators listed below.

Chart 1: US has seen 12 recessions since World War II, typically lasting around three quarters

Source: NBER, SBIMF Research

We looked at a simple average of %3m/3m annualized growth rate for these six indicators. At an aggregate, it points to a marginal expansion (0.4% 3m/3m ann. in Jan’23). Historically, US has been declared into recession when the aggregate of these activity indicators dips into contraction. As of Jan’23, industrial activity shows sharpest decline (-4.6% 3m/3m ann.), manufacturing and trade sales are weak (0 on 3m/3m ann.). While on the other hand, real income and non-farm payroll still holds up (2.1% and 2.5% respectively). Trend in these indicators point to a likely recession in the US by 3Q 2023 or latest by 4Q. Further, it is not necessary for all indicators to be in negative for NBER to call out a recession in the US (1960, 1973, 1981 being a case in point).

A typical US recession starts with roll down in business activity followed by job market slowdown

Industrial production and business sales are typically the first one to start weakening in any recession followed by employment (NFP and household employment). Household income and employment roll over few months later, but may not necessarily weaken as much (case of 1981, 2001). In 2001 – in what was the mildest US recession ever (real GDP barely declined) – employment fell in the first month of the recession, because of a drop in manufacturing jobs amidst an industrial recession. At the other extreme, during the most severe post-war recession (until COVID) in 2008, all the key components started to contract in Q1 2008, with consumption lagging by just a couple of months.

Chart 2: US dips to recession when the aggregate of these activity indicators posts negative print

Source: FRED, SBIMF Research; NB: Simple average of % 3m/3m ann of 6 coincident activity measures used by the NBER’s Business Cycle Committee

US is already amidst industrial recession with rapid moderation in global trade

For the past year, the US has been undergoing what might be described as step-by-step suppression of demand. Leading indicators are pointing to a downturn in the US manufacturing and construction (residential investment) sector resulting in a fall in US imports and new orders. The latest leg of the evolving slowdown is the one that the rest of the world is feeling- i.e. the demand impact of receding US imports.

But, with employment growth still strong, it is quite unlike the recessions of recent decades.

Chart 3: US ISM New Order in contraction since Sep’22

Chart 4: Global order inflows and trade volumes fall

Source: Bloomberg, SBIMF Research

Chart 5: US real import growth contracts

Chart 6: US Residential investment deeply negative

Source: Bloomberg, SBIMF Research

Strength in the US job market is the biggest issue today. Even as there are anecdotes of layoff, non-farm Payroll has been exceptionally strong. Unemployment rate at 3.4% is at record low. There are 1.9 jobs in the market today for every one person looking for job which keeps the wage growth elevated and inflation stickier than expected.

Illusion of Money: track corporate profits to understand job market

Typically, on most occasions of past recessions, the incremental hiring activity at least starts to flatten out/contract five to six months prior to recession. During 2008 GFC, negativity in jobs led the GDP growth negativity by 6 months. But during inflationary periods, it's not unusual for employment downturns to begin months, after the start of recession, i.e. we can be inside a recession and still have jobs growth. We saw that in 1973-75 and 1980 recession. This can be best described as illusion of money during inflationary times. Higher inflation leads to a delayed onset of profitability loss, which in turn delays the layoffs. Thus, in today’s time too, corporate profit will act as a leading indicator of job loss.

Chart 7: History of US inflation and the recession

Source: Bloomberg, SBIMF Research

Chart 8: During 1973-75 and 1980, healthy corporate profits kept the job market data strong

Source: Bloomberg, SBIMF Research

Table 1: 1973 and 1980 saw jobs growth even into recession

Source: Bloomberg, SBIMF Research; NB: t refers to the month of recession onset

Genuine inflation is nothing more than excessive money creation chasing too few goods.

While there have been notable supply side improvements, demand side of the economy remains strong supported by healthy wage growth. Along with that, the impact of structural factors relating to geopolitical factors and energy transition costs add considerable uncertainty.

Policy makers expected that 1970s recession would tame in inflation. But that did not happen as money supply growth was strong. 1970s had an excessive money supply growth which has been curtailed this time. Monetary tightening will eventually drive cyclical disinflation.

Chart 9: Money supply growth were elevated during 1970s feeding into stagflation

Source: Bloomberg, SBIMF Research

As monetary policy works with a lag, we could see its effect in coming months on both growth and inflation. And with growth likely slowing across much of the world, commodities will not be the source of inflation they were over 2021 and 2022 (though they may not see a material dip down either). The cyclical inflation will come down but there are structural changes in economy. Global trade has slowed post GFC. Constrained energy supply, falling productivity and geopolitics seems most credible threat to medium-term inflation. Consequently, while CPI could fall owing to significant tightening- we do not know if it could rise again as the monetary breaks go loose.

US Fed has been single-mindedly focussed on inflation to the extent of engineering recession but such aggressive hikes cannot be without no broken bones especially when leverage is high.

In the past three decades, Federal Reserve that has typically cut interest rates before the recession has even begun. However, 1973 and 1980 recession saw rate hikes owing to higher inflation and strength in job market data. Given that inflation, corporate profits and job market data rhymes closer to the decades of 1970s-80s, market has been consistently trumped in pre-empting rate cuts. US Fed has hiked rates by 475bps in the current cycle, guides for one more and then a long pause in 2023.

Table 2: 1973 and 1980 recession saw rate hikes owing to higher inflation

Source: Bloomberg, SBIMF Research; NB: t refers to the month of recession onset

We are witnessing synchronized and aggressive global monetary tightening at a time when industrial recession has already begun. We do not know how severe this recession is going to be. But the kind of aggression in rate hikes makes a case for more severe than for being it mild.

Chart 10: Synchronized policy tightening

Chart 11: And too high too soon.

Source: Bloomberg, SBIMF Research; NB: Global Central Bank policy diffusion index is based on sample of 30 countries

Leverage if the biggest problem today. The aggressive rate hikes of 1980s to single-mindedly tame down inflation was also made possible due to contained leverage in the system. US had successively managed to bring down its post war debt (from 95% of GDP in 1947 to 35% of GDP in 1980). Well, things are quite different today.

Government debt to GDP stands at 110%. Even as the real economy impact may be delayed, recent events in the US and European banking space confirmed, in case there was ever any doubt, that the fastest and most aggressive tightening cycle in four decades is having an impact. The entire last decade was built on era of low inflation, near zero rates and large-scale asset purchases. Today, financial institutions have found themselves inadequately hedged against interest rate risks. Further bouts of turmoil cannot be ruled out.

US Fed today: Damned if you do, Damned if you don’t.

Banking sector concerns led markets to price an abrupt end to the hiking cycle and a substantial probability of policy rate cuts. Well, that did not happen. Fed Funds rate was hiked by another 25bps in Mar’23 meeting and the dot plot remained unchanged implying one more hike and then a long pause in 2023

But market wants cuts- fast and deep. Inflation and employment backdrop is too strong for the US Fed to go all out in the support of financial stability. Either of the two thing has to happen for market expectations to materialize. If the earning recession that we spoke of commence and US start losing jobs or inflation solves for itself in next couple of months- that would help the Fed to lend an extra support on financial stability. Or another possible outcome is that more of Silicon Valley types issue spring up, leading Fed to prioritize financial stability over inflation.

To certain extent, the current banking sector episode in the US will translate into tighter regulations and profitability compression for banks, implying tighter credit conditions. In a fractional reserve banking system, this is the transmission mechanism slowing growth. But that aside, this financial turmoil will make it difficult for the Fed to fight inflation as hard as they desired. And that in turn means that market volatility will continue as investors keep betting on assets that have higher beta to dovish tilt and assets that do not.

How does US equity market behave during their recessions?

Both aggressive tightening thus far and concerns on financial stability implies slower growth going ahead and then key is to figure out how does market behave (we study equity and fixed income here) during growth corrections.

We studied past recession in the US and figured out that equity market starts to correct prior to recession onset but bottoms out even as we are into the recession- with few exceptions. One such exception is the equity market bull run of 1980s. During 1980s, we had three episodes of recession within a decade. There were small market corrections- but not meaningful given the extent of rally we saw during that period. One plausible reason could be massive decline in Fed Funds rate during the decade which could have led to equity valuation re-rating. Fed Funds rate fell from 20% to settle at 5% by 1990s. On the other hand, during 1973, 2001 and 2008 recession, S&P fell by ~50%. On other occasions, there has been ~20% corrections (1981, 1990 and 2020 recession). Currently, S&P has fallen 17% from its peak.

Thus, if history is any guide, there are more pains left and perhaps equity market should bottom out by end 2023.

Chart 12: 1973 Recession- market corrects 46%

Chart 13: 1980, 1981 and 1990 Recession

Chart 14: 2001 recession

Chart 15: 2008 Recession

Source: Bloomberg, SBIMF Research

When does Duration start to perform?

If one were to look at last two decades, the answer is very simple. Duration starts to perform at mature stage of rate hiking cycle. However, the high inflationary periods of 1970-80s were very different. 10-year UST rose into 1973 and 1980 recession. That could perhaps be explained by high inflation leading market to doubt the longevity of rate cuts.

Chart 16: 2001 Recession and 10Yr UST

Chart 17: 2008 Recession and 10Yr UST

Chart 18: 1973 recession and 10Yr UST

Chart 19: 1980s recession and 10Yr UST

Source: Bloomberg, SBIMF Research

On top of that, another angle is the financial stability concerns. 2008 GFC crisis was followed by sharp rate cuts. But in 1980s financial stability concerns had interrupted the hiking cycles but did not end them.

Mapping this history in the current context, sharp monetary tightening in last one year should drive cyclical disinflation- though one could argue that 2% inflation target may still be far-fetched. On top of that, the issues of financial stability could provide a breather to rate hikes. But like we said, we do not know as yet whether market today is mimicking the past three decades a long period rally in fixed income assets or 1970-mid 80s where the rally is short-lived and frequently punctuated with reversal in rate cycles.

2022 was one of the worst years for combined returns of stocks and bonds market in the US. In 2023, equity market prospects is still grim unless we see a significant dovish tilt by the US Fed and greater clarity on depth and breadth of recession. Outlook for duration assets is improving at the margin. That said, longevity of duration rally can be challenged unless inflation is brought under complete control.

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