Nick Timiraos’ headline for his Tuesday March 7th front-page article for the WSJ read. “Godot Recession Complicates Powell’s Bid to Tame Inflation” The article quotes Credit Suisse Economist Ray Farris, “ It’s the Godot Recession. By the middle of the year, people will still be expecting a recession in six months.” Mr. Farris may or may not be right about whether or not we will be in a recession by the middle of this year, but he makes a fair point that much of the Wall Street economic and market strategy world has been surprised by the durability of US consumer demand.

While many have expected that a recession would be here by now, I’m not aware of any well known sell-side or buy-side economist or strategist, who had anticipated a recession, capitulating on that point. Quite the opposite. The bearish consensus, of which I am in sympathy, figures the longer it takes, the sharper the downturn is likely to be. If demand remains so resilient that Powell and company bear it necessary to hike the Fed Funds rate to 5.75% or even 6%, the more painful the economic and credit cycle is likely to be.

Concessions of humility have had to be made of course, but nobody is saying, “ I really thought raising interest rates across the economy by more than 5% would make an impact, but apparently not.” There is a simple way to think about this: If you think cost of capital matters to consumers and corporations and if you don’t think the Fed can reduce inflation all the way down to 2% without unemployment going higher, your outlook is very unlikely to have changed.

So why has the consumer been so resilient? Mostly, because accumulated savings from the excessive fiscal stimulus has still not been exhausted especially for the top 20% of the economy. Savings levels are still significantly higher for those not living paycheck to paycheck than prior to the pandemic. There is also the argument that real wage growth has driven higher demand which intuitively makes sense. There are other contributions like the 8.7% COLA (Cost of Living Adjustments) increase fattening social security checks. Lastly, unseasonably warm weather like we had across the country in January always drives more shopping trips.  

The other critical consumer tailwind has been energy. Oil and subsequently gasoline prices peaked early last summer and have moved from down to flat since. It’s hard to overstate the importance of gasoline prices to not only inflation but also to consumer sentiment. Natural gas has collapsed, which means, along with that warm winter again, utility costs are down for consumers.

Unfortunately, looking at accumulated savings is, by definition, not forward looking. Real wage growth is likely to continue to slow as the economy slows. Demand is slowing. Profits are falling.  It is only then when profits begin to fall that more layoffs begin. That is all happening but slowly and unevenly across the economy.

The below chart comes by way of Eric Basmajian Founder of EPB Research.

The blue line charts the 6 month moving average of starts and permits while the red line shows the 6 month moving average of residential units under construction. You can see that the correlation has been very high with permits leading construction. When you look at this chart, is there any doubt in your mind that construction activity is about to go meaningfully lower?

Lower activity means layoffs. For a residential construction industry that employs over three million workers, that is going to matter to the overall employment picture. It hasn’t yet, construction jobs were still rising in the most recent non-farm payrolls report. Weaker housing also has a wealth effect dragging down consumer confidence and, in-turn, spending. I hate to repeat myself and I know I say this a lot, but housing leads the economy because of its interest sensitivity and housing is critically important to the consumer and the broader economy. Affordability is at worse levels than during the run-up to the GFC. While the lack of inventory is currently supporting prices from falling faster, affordability will ultimately mean revert as it always has. That means we likely need to give back a good part of the 38% trough to peak national average house price appreciation since the outset of the pandemic.

Just as construction activity follows permits, recessions follow deeply inverted yield curves. Companies will fail or shrink when capital becomes far more expensive and more scarce. The Fed is both making capital more expensive by raising interest rates and making capital more scarce by tightening liquidity. The most recent Senior Loan Officer Survey makes it clear that the lending environment is getting tighter. The Fed will win. It is economics 101 and from my perspective, an immutable law.  

So, if we have to have a recession, isn’t it likely that we have a mild recession and maybe that is already priced into the yield curve and the relatively buoyant stock market? Perhaps we will have a mild recession. After all, the long-term jobs picture in America looks pretty strong from a supply/demand standpoint. People have far more equity in their homes than during the GFC and far more have fixed rate mortgages. The issue I have with that scenario is that the developed world now faces inflationary pressure from secularly tight labor and energy markets which means the Fed Put isn’t going to be available. In other words, markets can no longer rely on the Fed to go back to the ZIRP (Zero Interest rate Policy) anymore.

The second concern was articulated by a San Francisco Fed working paper published this week titled: Loose Monetary Policy and Financial Stability. The authors concluded, “We find that when the stance of monetary policy is accommodative over an extended period, the likelihood of financial turmoil down the road increases considerably.” Well, both monetary and fiscal policy has been more than accommodative for a really long time and we simply don’t know how addicted we are the super cheap and abundant capital. We don’t know who is swimming naked until the tide goes out to use the Greenspan metaphor. We’re going to find out, we just don’t know exactly when.

For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

WealthVest makes no representation or warranty, expressed or implied, with respect to the accuracy, reasonableness, or completeness of any of the statements made in this material, including, but not limited to, statements obtained from third parties. Opinions, estimates and projections constitute the current judgment of Tim as of the date indicated. They do not necessarily reflect the views and opinions of WealthVest and are subject to change at any time without notice. WealthVest does not have any responsibility to update this material to account for such changes. There can be no assurance that any trends discussed during this material will continue.

Statements made in this material are not intended to provide, and should not be relied upon for, accounting, legal or tax advice and do not constitute an investment recommendation or investment advice. Investors should make an independent investigation of the information discussed in this material, including consulting their tax, legal, accounting or other advisors about such information. WealthVest does not act for you and is not responsible for providing you with the protections afforded to its clients. This material does not constitute an offer to sell, or the solicitation of an offer to buy, any security, product or service, including interest in any investment product or fund or account managed or advised by WealthVest.

Certain statements made in this material may be “forward-looking” in nature. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking information. As such, undue reliance should not be placed on such statements. Forward-looking statements may be identified by the use of terminology including, but not limited to, “may”, “will”, “should”, “expect”, “anticipate”, “target”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof or other variations thereon or comparable terminology.

The S&P 500® is a trademark of Standard & Poor’s Financial Services, LLC and its affiliates and for certain fixed index annuity contracts is licensed for use by the insurance company producer, and the related products are not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC or their affiliates, none of which make any representation regarding the advisability of purchasing such a product. WealthVest is not affiliated with, nor does it have a direct business relationship with Standard & Poors Financial Services, LLC.