Is A US Recession ‘More Fear Than Fact’?

Not everyone agrees a US recession is “inevitable,” as Bill Dudley put it a few weeks back. Or at least not in the next 12 months.

To be sure, a downturn is inevitable at some point. As Jeremy Grantham reminded the world in his latest, “we live on a finite planet,” which means generating perpetual compound growth is impossible. Over the longer run, innovation is the only way to forestall collapse.

Before I venture too far afield, I’d just note that everything has been faster this cycle. While there are good arguments for why recent curve inversions weren’t a harbinger of economic doom, there are always such arguments. And “this time” is rarely, if ever, “different.”

But calling for recession and getting the timing right are two entirely different things. Market timing is a fool’s errand, and in many respects, so is analysis aimed at calling time on expansions. For Wells Fargo’s Chris Harvey, it’s “odd that a market that did not anticipate the YTD selloff in long-duration assets or the Fed’s hawkishness is being consulted for the timing/magnitude of the next recession.”

That amusing excerpt came from an April 13 note in which Harvey failed to find a “bad actor,” a necessary condition for a recession. He looked at “the usual suspects,” including the consumer, stress in the financial system and corporates, all in an effort to “build a credible recessionary case,” to no avail.

In credit, Harvey observed a steady decline in Bloomberg’s bankruptcy index, which contrasts with increases in the lead up to previous downturns (figure below).

In fact, bankruptcies all but went extinct earlier this year. Only three firms with at least $50 million in liabilities filed in January, the slowest start to a calendar year on record. “One side effect of COVID is that it appears to have accelerated the ‘creative destruction’ of more marginal enterprises,” Harvey wrote. Some would quibble with that assessment. Indeed, the Fed’s unprecedented intervention in corporate credit markets led to binge borrowing by both IG and high yield issuers.

Although the door is still wide open for borrowers, 2022 hasn’t been kind to credit investors. IG is down some 10% for the year, and outflows have picked up materially. Between rates, slowdown worries and dour headlines out of Ukraine, it’s not terribly difficult to imagine spreads widening at some point, especially as financial conditions tighten and domestic economic fundamentals betray waning momentum.

In any event, Harvey called corporate balance sheets “solid.” He said the same of US consumers. “Corporate cash is 33% higher than it was in 2019 [and] the net debt/equity ratio has been slowly trending down for S&P firms,” he wrote, adding that “‘alt-A’ loans and excessive LTVs are not all the rage, stress tests have improved banks’ financial position and risk profile and pandemic restrictions in the US are easing.”

There was some good news on consumer psychology Thursday. Lost in the fog of Elon Musk headlines was a much better than anticipated read on University of Michigan sentiment, which printed well ahead of estimates, albeit still at levels that count among the lowest in a decade (figure below).

You can thank expectations for the beat. The outlook gauge rose nearly 10 points from March. Consumers’ inflation perceptions were unchanged on both the one-year and five-year horizons.

Harvey expressed confidence in the US consumer. “We do not expect the consumer to wilt given that jobless claims are at lows not seen since 1968 and US household net worth as of December 31 was at an all-time high of $150 trillion, suggest[ing] recession risk is more fear than fact.”

The familiar figure (below) shows you the progression of the post-COVID wealth bonanza by quarter.

There’s some merit to the contention that the US consumer should be fairly resilient, but I’m compelled to remind readers that when it comes to household net worth, the gains are attributable to equity ownership and home price appreciation. The majority of that wealth (to say nothing of remaining cash buffers built during the pandemic) is concentrated in the hands of the wealthiest Americans, who have the lowest marginal propensity to consume. We can’t depend on them to support the expansion. “Regular” people need to spend too, and for most workers, wage growth is negative in real terms.

Ultimately, you can count Wells Fargo’s equity strategy team among those who don’t believe a US downturn is imminent, “despite daily calls for recession from anyone with a megaphone,” as Harvey put it.

He did, however, concede that the risk of a Fed policy error is real. He referenced “geopolitical inflation,” where that means energy, agricultural prices and semis. “We believe the Fed would probably need to drive the US into recession to reduce demand enough to affect pricing for these goods,” Harvey wrote, adding that Wells “worr[ies] there may be a behavioral aspect that we cannot discount: Does this Fed want to be remembered for allowing inflation to return?”

It’s probably too late. This Fed will indeed go down in history for presiding over a harrowing jump in prices. Fortunately for Jerome Powell, there are any number of mitigating factors, including a once-in-a-century public health crisis and the first pure war of conquest since World War II.

The good news for stocks, Harvey suggested, is that any Fed-induced recession likely wouldn’t materialize until “well into” next year.