By and large, market commentators now begrudgingly concede that the odds of a US recession occurring over the next 12 to 24 months are very elevated. Generally speaking, though, they stubbornly insist any downturn will be mild.
Such wishful thinking is “a spurious landmark we pass at this stage in the cycle before all hell breaks loose and both the economy and markets collapse.” That’s according to SocGen’s Albert Edwards who, on Wednesday, wrote that with both a recession and a market “meltdown” looming, “familiar phrases are returning to greet me like long-lost friends.”
One of those phrases is the contention that a recession, assuming it occurs, will be “shallow.” Another is the notion that stocks have already priced it in. As you can imagine, Edwards doesn’t agree with either.
It’s not just that the Atlanta Fed’s GDPNow tracker is sitting (un)comfortably on the flatline. “The leading indicators look grim as well,” Edwards said, citing the Conference Board, and noting that ISM has some catching down to do, specifically to sub-50, contraction territory.
He also mentioned last week’s update to the New York Fed’s DSGE model, which produced unofficial forecasts that are “considerably more pessimistic” (to quote researchers including Marco Del Negro) than they were just three months ago. Among other things, the model now sees a “not-so-soft landing,” characterized by negative growth this year and next (figure below).
Note that DSGE model projections aren’t an official New York Fed forecast. They’re an input into the “overall forecasting process.” Whatever they are (or aren’t), they don’t bode especially well.
The color accompanying the latest update on the DSGE was blunt. “According to the model, the probability of a soft landing — defined as four-quarter GDP growth staying positive over the next ten quarters — is only about 10%,” the researchers wrote. “Conversely, the chances of a hard landing — defined to include at least one quarter in the next ten in which four-quarter GDP growth dips below -1%, as occurred during the 1990 recession — are about 80%.”
Edwards called those forecasts (sorry, model outputs) “quite shocking” and “extraordinary.” In a hard landing scenario, the Fed’s “unconditional” commitment to the inflation fight might suddenly become more… well, conditional, if you ask Albert.
“Let’s assume — plausibly — for a moment that the US economy does suffer a hard landing and the S&P collapse resumes apace. It goes without saying then that at some point rising unemployment and chaos in the markets will force the Fed to capitulate, or as they will euphemistically call it, ‘pause their tightening cycle!'” he exclaimed, adding that “the next step as the economy collapses will be to slash rates back to zero and resume QE.”
Arguments to the contrary implicitly assume that inflation stays sticky. After all, the only reason to keep hiking rates into the teeth of a recession is if inflation refuses to roll over. Edwards reckons it may be just a matter of time before headline inflation takes a dive as commodity prices collapse under their own weight. He pointed to the 2008 experience and also noted that, so far, yields have been unresponsive to a marked loss of economic momentum (figure below).
If headline inflation were to recede sharply, that could easily give the Fed plausible deniability to pause rate hikes. After all, Powell emphasized during last week’s press conference that regular people don’t even know what core inflation is.
And yet, Edwards suggested that any collapse in bond yields wouldn’t be sufficient to reestablish the trend of lower lows and lower highs that defined his “Ice Age” thesis. “The new secular trend may now be for higher inflation and higher yields,” he said, but only after warning that “a cyclical recessionary shock awaits.”