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.
Moreover, apart from this potential legislation, the U.S. economy should be experiencing significant fiscal drag in 2022. The Congressional Budget Office latest estimates still show the federal budget deficit falling from 12.4% of GDP last fiscal year (which ended on September 30, 2021) to 4.7% of GDP this fiscal year and 3.7% next fiscal year. Of course, this reduction in the deficit assumes no further stimulus legislation. However, apart from anything passed in the next few months, this may, in fact, be a quite realistic assumption, as Republicans are likely to take control of at least one house of Congress this fall and probably could not be induced to support further stimulus legislation unless the economy was demonstrably already in recession.
There is a strong argument that the fiscal policy has been too easy during both the Trump Administration and the Biden Administration so far, notwithstanding the obvious emergency caused by the pandemic. However, it would be a classic fiscal mistake to lurch from too much stimulus to too little.
The Federal Reserve could make a similar policy error. For almost 14 years, with the exception of a very brief period in late 2018 and early 2019, the Fed has maintained a negative real federal funds rate. This super-easy monetary policy has elevated asset prices and fostered financial speculation while doing little to actually stimulate economic growth. For this reason, the Fed should have begun to normalize monetary policy once it was clear that the economy was recovering strongly and adapting to the pandemic over a year ago.
By waiting, the Fed has left itself open to the charge that it has fueled inflation, which manifested itself, last week, in a 7% year-over-year increase in headline CPI. To some extent, this particular criticism is misdirected. The Fed’s easy money policies have contributed to fast-rising prices of homes and financial assets. However, soaring prices of consumer goods and services have much more to do with supply chain disruptions and earlier fiscal stimulus.
That being said, the Fed has now clearly pivoted to a much less dovish position. Their bond purchase program is on track to end in two months and multiple Fed speakers have now argued for a first increase in the federal funds rate in March. In addition, the minutes of the last FOMC meeting show that they are now actively looking to reduce their mammoth $8.8 trillion balance sheet with an eye to maintaining an upward slope on the yield curve as short-term rates rise.
If they carry through with this policy shift they may well succeed in boosting the 10-year Treasury bond yield to between 2.5% and 3.0% from its current 1.8% by the end of this year. This would likely entail a parallel upward shift in mortgage rates, slowing the housing market. Finally, this tightening could lead to a significant correction in financial markets, negating some of the huge gains seen in household net worth in recent years.
As with fiscal policy, if the economy were actually to fall into recession, this tighter monetary policy would surely be reversed. But by then, the damage would have been done.
If a recession were to occur, it would likely be shallow and short-lived. The recession, particularly if mirrored by a global slowdown, would likely mop up excess demand in the economy, returning the economy to a somewhat lower inflation environment. However, divided government would likely preclude significant fiscal stimulus while the Federal Reserve, chastened by the current inflation experience, might be less aggressive in deploying monetary easing to stimulate the economy than in the last two recessions.
For investors, a year of rising interest rates followed by a recession would represent a double challenge to more speculative investments. Higher rates would obviously be a problem for long-duration bonds and high-P/E stocks as well as more esoteric investments such as cryptocurrencies and NFTs. A more traditional recession, without the stay-at-home characteristics of the last one, would be much less profitable for goods retailers and technology companies. And a U.S. recession that put an end to Fed tightening could be dollar negative, enhancing the relative returns on overseas assets.
As I said at the outset, we don’t expect a near-term U.S. recession. It isn’t our baseline scenario. However, investors should diversify not because of what they expect but because of what they never expect that ends up biting them. It is also worth emphasizing that the pandemic recession and recovery have led to a very wide dispersion of valuations across capital markets. Any new scenario, which starts with increasing interest rates, has the potential to narrow that dispersion suggesting that, whether investors expect a recession or not, they should take steps today to ensure that they are not overweight in those assets that are obviously overpriced.
David Kelly is chief global strategist at JPMorgan Funds.