Our baseline view of the world does not include a U.S. recession in the next two years. However, it is certainly possible, and investors would be well advised to consider what it might mean for their portfolios. With that in mind, it is worth thinking about what could cause a U.S. recession, the implications of such a recession for financial markets, inflation and monetary and fiscal policy and how assets would fare in its wake.
The normal condition of the economy is one of steady growth. Indeed, since 1950, the economy has been in recession only 13% of the time and been in recovery or expansion the rest of the time. This makes logical sense. After all, in normal times, both the labor force and productivity should be growing slowly and most people feel motivated to work, consume and generally get ahead.
However, since 1950, the U.S. economy has fallen into recession 11 times and three factors have usually contributed to this outcome.
1. The economy was close to full employment before the onset of the recession.
2. The economy got hit by a major shock or surprise and,
3. Policy makers made some mistake, which worsened the situation.
On the first of these factors, an economy that has reached full employment will normally grow more slowly as it will lack the extra employment and output growth that comes from reemploying laid-off workers. Slower growth, in itself, makes the economy more vulnerable to recession since it has less momentum to offset any negative shock.
Today, with an unemployment rate of 3.9%, strong wage growth and 10.6 million job openings, the U.S. economy is clearly very close to full employment. Some further labor force growth could be achieved by workers returning who, for medical or dependent care reasons, couldn’t participate in the height of the pandemic. However, given a wave of baby-boomer retirements and a continued lack of immigration, we expect employment growth to slow sharply in 2022 from the 6.4 million jobs added in 2021. Absent an extraordinary surge in productivity, the growth rate of the U.S. economy could well fall from 5.5% year-over-year in the fourth quarter of 2021 to roughly 2.5% year-over-year by the fourth quarter of 2022.
It should be stressed, however, that given the supply difficulties of the past two years, there should still be more pent-up demand in the economy, even in late 2022, than is normally the case when the economy is close to full employment. This is a key reason why we see recession as a possibility rather than a probability.
The second of the factors that lead to recession, some kind of shock, by definition can’t be predicted. However, one obvious candidate would simply be further significant damage from the pandemic. There are signs that the U.S. omicron wave is cresting at about 800,000 confirmed cases per day. However, even if it is, and despite the fact that omicron is clearly milder than previous variants, the pandemic continues to take a terrible human toll, with close to 2,000 people dying of Covid every day.
From an economic perspective, the negative effects of the omicron variant are also becoming clear. Airline travel and restaurant table reservations were down 13% and 16% respectively in December from pre-pandemic levels but are now both down an average of 27% over the past 11 days. Meanwhile every industry in the nation is struggling with staff shortages due to people calling in sick. Partly because of this, we expect real GDP growth to fall to roughly 1% annualized this quarter from roughly 7% last quarter. If omicron is truly the last major wave of the pandemic and life returns to normal by March, the second quarter should see a solid rebound in economic activity. However, if Covid lingers, it could continue to restrain leisure and entertainment spending and labor supply throughout the year.
In addition, there is clearly a growing omicron risk in China. Since the initial outbreak in Wuhan, China, has been successful in suppressing the virus through draconian lockdown measures. However, as Covid variants have become more contagious, this becomes an ever more challenging strategy. This is particularly the case as vaccines, even if they normally reduce the severity of Covid symptoms, are proving ineffective at preventing the spread of new variants. In recent weeks, and in the lead up to the winter Olympics, Chinese authorities have been playing a game of whack-a-mole against Covid with new daily cases still only numbering between 200 and 300 but outbreaks now being reported in more than a dozen separate administrative districts. There could well come a time, perhaps quite soon, when omicron gets completely out of hand in China, resulting in widespread shutdowns across the entire economy.
If, eventually, the virus wins, China would, of course, experience a terrible medical crisis but also one that, for a few months, would inflict further pain on global supply chains while slowing global GDP growth. Within a few months, China’s omicron wave would subside but the economic damage would have been done.
And then there is the question of policy. On the fiscal side, the President’s Build Back Better plan is stalled in Congress. By February 18, a new continuing resolution will have to be passed and this or other legislation could contain some provisions of the Build Back Better plan. However, this is likely to involve little net fiscal stimulus as any compromise that can pass the Senate will likely include higher taxes to pay for higher spending on a year-by-year basis.