Where to from here?

“Recession! That’s where.” Or so goes the refrain from seemingly everyone inclined to weigh in on the macro trajectory at a time when the market-implied odds of a US downturn exceed 50%.

Of course, calling recessions isn’t an exact science. Even the yield curve’s purportedly perfect track record relies heavily on a rather malleable interpretation of the term “prescience.” The lags between inversion and downturns are “long and variable,” to employ the obvious joke.

As a related aside, it’s not even clear whether we’re saying anything worth saying when we tout curve re-steepening from cycle lows as an even more reliable recession canary. After all, bull steepeners in that context are predicated on expectations for policy easing. And policy easing is generally a response to evidence of macro deterioration. That’s a bit self-referential.

In any event, recession banter is all the rage, even as some would argue the prospects for a soft landing have actually improved. “The news cycle has swung back to recession talk, even as inflation is coming down and unemployment is at a 50-year low,” Claudia Sahm wrote over the weekend. “Ask people what they’ve heard about the economy, and they’ll tell you it’s bad,” she added.

True indeed. One way or another, the Fed’s hiking cycle is essentially over. It’s almost surely “one more and done” from here, notwithstanding hawkish allusions to unfinished business. Assuming the economy is slowing and rate hikes are just weeks from being concluded, the next battle will be the Fed versus the recession. Markets still suspect rate cuts may commence later this year, but some worry it’ll be too late.

“[The] best [way] to tell who’s winning” will be to monitor high yield, homebuilders and semiconductors, BofA’s Michael Hartnett remarked, weighing in on the forthcoming “recession versus Fed cuts” zeitgeist. If HYG <73, XHB <70, SOX <2900, it’s a recessionary signal, he said. If those levels hold, though, “it’s a no/soft landing.”

As we saw in February, when markets began to react to January’s run of hot macro data and, more to the point, the read-through of that data for Fed policy, a “no landing” situation can be a source of consternation to the extent it telegraphs persistent inflation.

You can see the tension, Hartnett suggested, in the long bond. “Inflation is slowing, the Fed hiking cycle is over [and] recession expectations are universal, yet 30-year Treasury yields can’t break below 3.6%,” he said. (That’s the 200-day.)

Why the trouble? Well, “because we’ve already traded 8% to 4% CPI, the labor market [has] yet to crack [and] the US government deficit is growing too quickly,” BofA wrote.

That’s yet another manifestation of what I’ve variously characterized as a kind of macro stalemate. It’s also reflected in what still looks like a yawning disconnect between small businesses’ perception of credit availability and jobless claims which, while starting to catch up (or down, in the context of the inverted axis on the left below), have only done so because the data was revised.

Meanwhile, the earnings recession consensus begrudgingly got around to collectively predicting, is expected to be very shallow. “Consensus forecasts a tiny -4% haircut in the meekest of recessions in 2023, and thereafter a renewed surge in EPS to $242 by Q1 2025,” Hartnett went on.

Note that if aggregate, index-level EPS were to achieve levels consistent with current out-year projections, it’d mark a 70% earnings increase from the COVID lows. As the figure on the right above makes clear, the peak-to-trough drop in earnings consensus is penciling in for 2023 barely counts as a blip, and bears no resemblance to the EPS drawdowns witnessed during the last three recessions.

There again, we see the tension. The resilience of corporate profits is a function of still robust nominal GDP growth and corporate pricing power. The political environment is such that there’s little in the way of appetite for cooler nominal growth, and as long as there’s demand, management will “profiteer” and “Greedflate,” frustrating calls for a more pronounced profit recession.

As noted here in the week ahead preview, it’s anyone’s guess how all of this will be resolved. For whatever it’s worth, Morgan Stanley’s leading EPS indicator (which Mike Wilson habitually refers to as a harbinger) isn’t the only model which suggests consensus bottom-up is nowhere in the ballpark when it comes to accurately forecasting the scope of a prospective profit crunch. BofA’s global EPS growth model tips a 16% drop in EPS by August.