- We think that Fed tightening will drive the economy into recession in Q2 (or a little later). This downturn is necessary to bring inflation back to target.
- The market looks more optimistic, with pricing putting a lot of weight on the possibility of a soft landing. This modest slowing in growth is then seemingly sufficient to tackle inflation, setting the stage for Fed easing later this year.
- We have developed a data tracker to tell us which of these stories is playing out, focussing on a range of leading demand indicators, and measures of how the supply side is shaping up.
- This tracker should help signal if our call is unfolding in a timely manner, which would force the market to price a more challenging macro outlook.
- It will also identify if the economy is shifting in a different direction. There is a growing risk that financial conditions need to tighten further to bring inflation under control.
Two questions to understand the US outlook
- First, is a recession necessary to bring US inflation under control, or can this be achieved through a soft landing in growth?
- And second, is the tightening in policy and ultimately financial conditions already delivered set to push the economy into recession?
We would answer yes to both of the questions above, and expect a downturn to set in over the next 3-6 months. This leads to quite a quick fall in inflation, and a more rapid than currently-priced policy easing through late 2023 and 2024.
To validate this, we would expect to see short term growth indicators deteriorate in the coming weeks and months, with this likely to show up clearest in leading indicators such as survey data, capex proxies and initial unemployment claims.
Meanwhile, we would not expect to see significant improvements in the supply indicators which are helping drive high inflation, or measures of price pressures themselves. These include measures of labor market tightness, supply chain dynamics, and wage growth.
Meanwhile, the market would seemingly answer no to both questions. A recession is not priced in, but a slowdown in inflation is. Moreover, this slowdown is expected to be enough to give the Fed scope to ease in late 2023.
If this plays out, demand indicators would remain more resilient, while improving supply side indicators would facilitate an improvement in the inflation backdrop.
Figure 1: Two critical questions for understanding the US outlook
The matrix above looks at different combinations of answers to our questions. What if growth holds up, potentially helped by the recent easing in financial conditions, but inflation remains unsustainably strong? In that case the Fed would be forced to retighten financial conditions to levels that were consistent with driving the economy into recession, if committed to hitting its inflation target.
This scenario would force markets to price a higher terminal Fed Funds Rate and a subsequent downturn in activity and corporate earnings. This would clearly be a painful process.
The final combination is that the economy is set for a short-term recession, but that this is not required to bring inflation back under control.
With hindsight this would imply the Fed has committed a policy mistake in overtightening in 2022 and early 2023, when the drivers of inflation were in fact more transitory than it feared. In this scenario a deterioration in activity indicators would be accompanied by improving supply side proxies and rapidly cooling price pressures.
What would this mean for markets? Certainly, they would have to adjust pricing for corporate earnings, hurting the equity market. However, it could at least price a very rapid series of interest rate cuts, as the Fed quickly reverses its policy tightening, supporting duration and providing at least some consolation for stocks.
Tracking this debate in real time
The table below highlights some of the activity, supply side and inflation indicators that we have flagged trough this note as critical to monitor. We look at the recent trend of each, and where it stands benchmarked against its history.
These data do suggest growth is slowing, particularly when we look at housing activity and forward-looking survey data. But conditions remain some way away from those we would consider consistent with recession.
Supply and inflation indicators meanwhile remain generally stretched, with the labor market still clearly very tight, wages rising strongly and productivity subdued. At the margin there has been some improvement, and we will need to watch carefully for signs of further progress.
Indeed, the point of this exercise is to create a tracking tool. And we have set out how we would expect these indicators to evolve in each of the scenarios discussed above. This should help provide us with a framework for understanding in real time if our assumptions are playing out or not.
Mapping the US outlook is challenging against the backdrop of the largest inflation scare in 40 years. Markets believe this outbreak can be resolved in a benign manner, with relatively little economic pain required to drag inflation back to target.
Our tracker should help determine if this optimism is correct, or if our base case, or another one of the more challenging scenarios we have identified, will play out.
Figure 2: Leading indicator tracker
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.