Last year, most of Wall Street’s major analysts and portfolio managers believed that the US economy would inevitably slide into recession in 2023 as the Federal Reserve hiked interest rates. The only real question is how bad will it turn out?
But as investors enter the second half of 2023, signs of economic weakness are still rare. This has led some to finally abandon the notion that a recession is imminent.
Goldman Sach’s chief economist, Jan Hatzius, recently dismissed the notion that a recession was ahead, while JP Morgan’s chief global market strategist, Marko Kolanovic, said the chances of a so-called “soft landing” for the US economy were increasing.
As the will-or-no debate continues to rage on Wall Street, the team of economists at UBS Group UBS, -0.02% decided to take a closer look at some of the factors that have helped support the US economy.
Monetary policy is not too tight
Since last spring, the Federal Reserve has been raising its policy rate, which in many ways determines the cost of money in the US, at the fastest clip since the early 1980s, according to UBS and others.
The Fed’s policy rate target ceiling cap has risen from 0.25% in early March 2022 to 5.25% recently. Many expect it to rise to 5.5% when the Fed meets next week.
At the same time, the Fed has been shrinking its holdings of Treasurys and mortgage bonds by choosing not to reinvest principal as some of these bonds mature.
Nonetheless, the team at UBS still sees the Fed’s policy stance as relatively soft.
“By many measures, monetary policy is only moderately restrictive, and has been that way for less than six months — neither condition is likely to be sufficient to push the economy into recession,” the UBS team said in a note.
Fiscal spending drives growth
Federal government spending helped keep the economy afloat through the pandemic in 2020 and added trillions of dollars to the national debt, before retreating in 2022.
But the fiscal contraction stopped last summer, and since then, spending has increased year-over-year.
This has helped give the US economy a boost, said the UBS team.
“Fiscal policy has implicitly turned expansionary again over the last six to nine months,” said the UBS team. “This means that fiscal policy is more of a tailwind than a headwind for economic growth this year.”
Household debt can still be managed
Stimulus checks paid by the government to households, increased unemployment benefits, the Paycheck Protection Program and other pandemic-era programs helped American households build wealth during the pandemic.
As inflation eased this year, many Americans found themselves with excess savings in reserve. Partly as a result, the latest University of Michigan Consumer Sentiment Survey shows US consumers are more optimistic than at any time in nearly two years.
Consumers and businesses are not over-borrowing
The business cycle theory states that the seeds of a recession are sown during boom times.
In a typical economic cycle, excesses in the private sector tend to increase as expansion progresses, especially during periods of strongest growth. Both households and firms are becoming overly optimistic about their prospects. This leads to over-borrowing by households and over-investment and over-hiring by businesses.
“While we view the economy as end-of-cycle, there are not as many excesses as is usual in the private sector. Ratios such as household debt to disposable income or corporate debt to GDP are not stretched,” said the UBS team.
One example is the ratio of household debt to GDP, often cited by economists as a measure of consumer health, which appears to be manageable.
Fear of ‘credit crisis’ never arrived
Following the collapse of Silicon Valley Bank earlier this year, analysts on Wall Street warned that the bank will limit the amount of credit offered to customers. The looming credit crunch is expected to be severe and some postulate that it might help the Fed’s campaign against inflation.
That’s not what happened. Instead, banks continue to make loans to even the least creditworthy companies, as the chart below shows – which measures the issuance of so-called “junk bonds.”
A tight labor market drives growth
Demand for workers is arguably the most significant factor keeping the US economy out of recession territory, says the UBS team.
More than 25 million jobs have been created since the US economic recovery began in May 2020, according to US government data and JOLTS (Job Openings and Labor Turnover Survey) data showing there are still around 10 million job openings.
The post-pandemic world is still a mystery
The once-in-a-century pandemic of 2020 and the subsequent response from fiscal and monetary policymakers have pushed the US economy into uncharted territory with little, if any, historical precedent.
Predicting what will happen in economics and finance has always been very difficult, but in the brave new post-pandemic world it has become practically impossible.
“The pandemic and now the post-pandemic economy is unlike anything economists and investors have ever experienced. This makes it increasingly difficult to determine how well the economy is performing and the likelihood of a recession,” said the UBS team.
The economy is in a ‘rolling recession’
When COVID-19 first spread around the world, demand for goods soared, while demand for services such as travel plummeted. Now, as recovery progresses, the opposite is true.
That’s the basis of a rolling recession: manufacturing can be in recession while the service sector of the economy booms, and vice versa. The following is the explanation of the team at UBS.
“The first year of economic recovery during the pandemic is often described as K-shaped because of the difference in wealth in the goods sector, which soared, and the services sector, which was hit harder and was much slower to recover.”
“The manufacturing sector recovered relatively quickly due to demand for goods. Once spending patterns start to return to normal in 2022 and demand for goods falls, manufacturing output will soon follow.”
“As a result, manufacturing output has shrunk since last fall and is effectively in recession. Now that spending on goods, especially autos, has picked up again in 2023, the manufacturing sector should be able to avoid a deep slump and start to recover by the end of the year.”
The service sector is more resilient
Data from the US Institute of Supply Management (ISM) has shown for months that manufacturing activity has slowed more than the services sector of the economy. But because services make up nearly three-quarters of the US economy, their resilience has shielded the broader economy from a downturn.
The ISM’s manufacturing sector survey for June was at its weakest since May 2020. It fell to 46%, down from 46.9% in the previous month, a decline for an eighth month.
In comparison, the ISM barometer for the services sector rose to 53.9% in June, beating forecasts of 51.3% and rising for the sixth month in a row.
The expansion period grew longer
Simply put: Over the past century, the average period of economic expansion has grown longer, while recessions have become much less frequent.
Here’s UBS with more on this:
“The best illustration of how this structural change in the economy has reduced the risk of recession is the substantial increase in the average length of expansion over the last four decades. From 1854 to 1982, the expansion averaged 2.8 years, with an average of 2.2 years from 1854–1919 and 3.4 years from 1919–82. But the four expansions since 1982 last an average of 8.6 years. The evolution of economic activity that has contributed to the extended expansion is unlikely to change suddenly in a post-pandemic economy.”
To be sure, many Wall Street investment banks are still predicting a recession will start later this year, or possibly as early as 2023.
But not everyone agrees on what a recession will look like. in the US, National Economic Research Bureau is the official mediator in the length of a recession which is defined as a significant reduction of economic activity spread across the economy that lasts more than a few months. The US economy registered a contraction in gross domestic product for two consecutive quarters in 2022, but NBER decided that this period was not significant enough to declare a recession.