Mark Vitner

Three of the prior soft landings resulted in substantially longer economic expansions. The first was in the 1960s, when the Fed raised the federal funds rate from 3.50% in November 1964 to around 5.70% in November 1966. The rate hikes worked, with real GDP growth slowing and inflationary pressures subsiding. The Fed was able to subsequently pull rates back below 4% in May 1967. The expansion continued for another 4 years, although inflation flared back up and the Fed had to hike interest rates even higher in the late 1960s, helping send the economy into recession in 1970.

The next most notable success occurred in the mid-1980s when the economy came roaring back from the deep 1981-82 recession. That recession broke the back of the hyperinflation of the late 1970s and early 1980s, seeing the year-to-year change in the headline Consumer Price Index fall from 14.8% in March 1980 to just 2.5% by the middle of 1983. After real GDP came roaring back at a torrid 7.9% pace in 1983, the Federal Reserve initiated a series of interest rate hikes that took the federal funds rate to 11.6% in August 1984.

The Fed’s tough medicine worked, and economic growth slowed to just a 3.7% pace in the second half of 1984 and first half of 1985. That soft landing gave the expansion some breathing room, and growth continued into what became known then as the longest peacetime economic expansion on record.

The long 1980s economic expansion came to abrupt end shortly after Saddam Hussein invaded Kuwait and oil prices doubled overnight. The surprise invasion of Kuwait upended what looked like another successful Fed operation, which saw the Fed raise the federal funds rate from around 6.5% in early 1988 to 9.8% in May 1989. The Fed was gradually cutting interest rates in the year and a half prior to the Kuwait crisis, as it appeared the economy was in the early stages of soft landing.

The 1990 experience reveals one of the most obvious shortcomings of soft landings.  When the economy slows below its potential growth rate, there is less ability to absorb an unforeseen shock. The business cycle is never going to be repealed, however. Recessions are ultimately caused by the buildup of imbalances during the economic expansion. There were plenty of imbalances present prior to the 1990 downturn, including a vastly overbuilt commercial real estate sector and weakened financial sector, which was reeling from the collapse of the Savings & Loan industry and a handful of large bank failures.

Despite the near miss in 1990, the Fed was successful at achieving another soft landing in the mid-1990s, taking the federal funds rate from 3% to 6% between February 1994 and March 1995. The rapid increase in interest rates was not without incident, as it triggered a financial crisis in Orange County, California – whose finances were unprepared for a sudden spike in interest rates. Problems also surfaced in Mexico, which saw its currency plummet as it had problems servicing its debt. The economy was strong enough to withstand those exogenous events, however, and growth continued for another five years.

As in the decade before, the Fed appeared to have engineered another soft landing in the year 2000, only to see unforeseen events subsequently pull the economy into recession. The Fed was raising interest rates at the end of the decade, as the economy was enjoying a strong burst of growth from business investment in IT infrastructure ahead of possible Y2K disruptions, as well as a surging stock market. The economy made it through Y2K without incident and was even weathering the selloff in the stock market reasonably well through much of 2021 before the September 11 attacks on the World Trade Center and Pentagon pulled the economy into recession.

The last time the Fed was able to pull off a soft landing was in the period just prior to the Pandemic, and whether this period qualifies as a soft landing is debatable. The Fed began to raise interest rates back in July 2017, lifting the federal funds rate from 1% to 2.4% in July 2019. The rate hikes successfully slowed the economy, and the fed began cutting rates later that year, pulling the federal funds rate back to 1.75% in February 2020. The COVID-19 Pandemic shut down the economy in March 2020, prompting the Fed to immediately cut the federal funds rate to zero. Without the pandemic, the Fed would have likely continued to gradually cut interest rates in 2020 and the expansion would have likely continued.

What does history tell us is likely to happen today? The Fed’s interest rate hikes over the past 18 months have been among the most aggressive ever, with the Fed raising interest rates from just 0.10% in March 2022 to around 5.40% currently. The 530-basis-point rise in the federal funds rate is the fastest since 1973, although the first 165 basis points essentially reverses the emergency measures put in place at the start of the pandemic – a point that is often overlooked but has played a critical role in extending the time that it has taken for higher interest rates to impact the broader economy.

As in the 1990s, the unexpectedly rapid interest rate hikes this past year did not occur without incident, contributing to the collapse of Silicon Valley Bank and to a general pullback in bank lending. Despite these setbacks, positive surprises outnumbered negatives surprises during the first half of this year, which has bolstered hopes the economy is on the verge of a soft landing. The latest data point to support that notion has been the continued moderation in employment growth, with the latest data showing employers added a more modest 187,000 jobs in July.

We continue to believe talk of a soft landing is premature. The economy benefited from a remarkable string of positive surprises during the first half of the year that likely will not be repeated during the second half and may even be reversed. Among the more consequential surprises was that inflation eased much more quickly than expected, with the year-to-year change in the headline CPI falling from 9.1% in June 2022 to just 3.2% in July 2023.

Most of the decline in the headline CPI this past year has come from a rapid decline in energy prices, which was largely brought about by President Biden’s decision to significantly draw down the Strategic Petroleum Reserve. Gasoline prices have fallen 20% over the past year. Falling energy prices are responsible for the bulk of the 5.9-point drop in the year-to-year change in the headline CPI over the past year. The drop in energy prices has also played a major role in slowing the pace of price increases at the grocery store, as transportation costs account for a large proportion of food prices.

Unfortunately, falling energy prices have likely provided all the relief that they can. The Strategic Reserve has largely been emptied, removing that backstop. Oil prices have recently rebounded back above $80 a barrel and gasoline and diesel prices have been edging higher. Grocery store prices are also likely headed higher, as persistent drought across the U.S. and other important agricultural producing nations push prices higher. In addition, the loss of shipments from Ukraine is tightening grain inventories and sending prices of several key products produced in the region notably higher.

There are other areas where the moderation in inflation should prove more enduring. Used car prices – another persistent problem area since the pandemic – have fallen back in recent months, as supplies of new cars have increased, and consumer demand has leveled off. Price increases for other goods have also moderated, as supply shortages have largely been alleviated. The most problematic area of inflation has been core services, which includes residential rent and owner equivalent rent. Rents are clearly moderating and will continue to slow the pace of core services prices.

Prices for services where labor makes up a large proportion of costs remain problematic, however. Wages are still rising around 4.5%, and with productivity stuck at around 1.5% or less, that pushes prices up at least 3%. Moreover, contentious labor negotiations between the United Auto Workers and major motor vehicle producers could set the stage for large pay increases in general, making it much more difficult to bring inflation back down to 2%.

The second biggest surprise of the first half of 2023 was that housing proved remarkably resilient. After mortgage rates spiked above 7% in November of last year, builders and realtors dealt with a spike in contract cancellations that pulled home sales substantially lower at the end of last year. Mortgage rates fell back to 6% in January, however, which brought many buyers back into the market, lifting new home sales in January and existing home sales in February.

The rebound in existing home sales proved short-lived. With roughly 80% of outstanding first lien mortgages fixed at 5% or less, and 60% at 4% or less, relatively few homeowners with a mortgage have been interested in selling their home and buying another with a mortgage around 7%. As a result, inventories of existing homes have remained exceptionally tight, which has completely reversed the moderation in home prices during the second half of last year.

The lack of existing homes for sale has been good news for home builders, which have seen increased buyer traffic and are enjoying stronger sales. The existing home market is more than 5 times larger than the new home market, however, which means residential investment is still a net drag on overall growth. Existing home sales provide commission income to realtors and fee income to mortgage lenders, as well as drive home improvement outlays and purchases of furniture and household appliances, all of which have been lagging.

The second half of the year looks to be even more challenging for the housing market. The combination of higher mortgage rates and rising home prices has made housing even less affordable. The latest data show that a family earning the median family income purchasing the median priced home, with a 20% down payment, will have to commit a record 28.5% of their income to principal and interest payments. That share almost certainly rose higher in July when both mortgage rates and housing prices rose further. Moreover, property taxes and the cost of home insurance have spiked in the past year, reflecting higher home values and higher replacement costs.

Another surprise is that higher interest rates did not take a heavier toll on household and corporate balance. Debt service costs remain relatively low for households and businesses, which has freed up more income for spending and investment. Stronger balance sheets are a holdover from the pandemic era, when record low interest rates and easier credit allowed households and businesses to refinance their debt at lower rates.

Higher interest rates are beginning to bite, however. Interest rates on car loans have risen substantially over the past year, which has slowed new and used light vehicle sales. Businesses are also having a harder time rolling over maturing debt at affordable interest rates and terms, leading to an uptick in bankruptcies and most likely some pullback in business fixed investment and staffing during the second half of this year and in 2024.

The unexpected Artificial Intelligence boom that followed the release of ChatGPT was another huge positive for the economy in the first half of 2023. The AI boom helped send stock prices higher and even led to a modest uptick in office leasing in Silicon Valley. What started as an incredibly narrow rise in share prices has broadened, which has revived consumer confidence. The AI boom has also bolstered IT equipment spending and employment. As with other booms, the initial uptake probably has a bit of hype tied to it and we expect the boost to investment and employment to fade somewhat during the second half of this year.

The last major surprise of the first half was the rapid uptake in major fiscal initiatives, particularly the Inflation Reduction Act, which is helping fuel a boom in Electric Vehicle-related infrastructure, such as EV battery plants, EV assembly plants and the production of related parts and charging stations. The CHIPS and Science Act has similarly led to a surge in semiconductor plant construction around the country. When combined with the pre-existing trend of reshoring, manufacturing construction has surged, with the latest data showing construction spending for private manufacturing facilities through the first 6 months of 2023 running a stunning 74.3% ahead of the same period 1 year ago.

We see the momentum giving way during the second half of the year. Customer demand for EVs has been underwhelming, which will likely lead to some slowing in EV investment. Semiconductor plant construction is also likely to moderate a bit, as credit becomes dearer and more costly.

Given the boost from fiscal stimulus it is surprising that interest rates were another area where the economy caught an unexpected break during the first half of the year. While the Federal Reserve hiked rates in line with expectations, Treasury yields were actually a little lower than expected, as the showdown over the debt ceiling meant the Treasury had to stretch their available funds a bit further than usual. The drawdown in the Treasury’s General Account meant there was less Treasury issuance during the first half of the year. The Treasury will now have to rebuild their General Account, which means issuance is set to increase. Moreover, tax revenues have been coming in lower than expected while spending is rising faster than expected. The net result is the Treasury will have to raise close to $2 trillion during the second half of this year, which will likely put some added pressure on long-term rates.

 We Are Looking for a Softish Landing

While the odds of a soft landing have clearly increased, we remain more cautious. We believe a remarkably fortuitous run of economic and geopolitical events during the first half of the year have made the prospect of a soft landing appear to be closer than it actually is. Many of the positive surprises, such as the surprising strength in home sales, have largely run their course. Others, such as the short-lived break in long-term interest rates the economy enjoyed in the run-up to debt-ceiling deal, now appear set to reverse as the Treasury refills its coffers. The Fitch downgrade of the U.S. credit rating may mark a turning point, where the economic news turns less positive.

The bulk of the improvement in the inflation data also appears to be behind us. Oil prices have recently rebounded back above $80 a barrel, which will result in higher gasoline and diesel fuel prices. Food prices will also likely prove more problematic given the prolonged drought across much of the U.S. and renewed disruptions to shipments of key products out of Ukraine.

Recessions are ultimately caused by the buildup of imbalances in the economy and there are a few notable ones to keep an eye on. Commercial real estate is the most obvious trouble spot, with uncertainty about the demand for office space leading to a spike in office vacancy rates for class B and class C properties and a substantial drop in property prices. Other areas of commercial real estate are less troubled, but higher interest rates and higher operating costs are weighing on returns and prices.

The problems in Commercial Real Estate are weighing on the banking sector, where Moody’s recently downgraded 10 regional banks and appears poised to downgrade more in coming weeks. The inverted yield curve has made bank lending less profitable at a time when many banks are now having to boost rates on money market accounts and CDs to stem the slide in deposits.

Housing affordability is another imbalance. In addition to the near record share of income needed to service principal and interest payments, property taxes and insurance costs have surged this past year. Prices will eventually have to correct, and our forecast has this correction occurring via slower price appreciation, lower interest rates, and continued moderate income growth.

One of the more glaring imbalances is the nation’s persistent trillion-dollar budget deficits. Debt relative to GDP has approached levels last hit in World War II. Interest on the national debt is increasing rapidly. Deficits are like high cholesterol. Everyone knows they are bad and increase the risk of a traumatic event, but it gets a bit murkier when you try to pinpoint just when such an event will occur. Treasury issuance is set to spike during the second half of this year, which introduces an element of risk into an economy where inflation will likely prove surprisingly persistent, and banks will also likely be scrambling to raise capital.

We are looking for a softish landing for the economy over the next few quarters, with real GDP growing at just a 0.7% annual rate between the middle of this year to the end of 2024. We also see two consecutive quarters of declining real GDP late this year and early next year, which we expect the NBER to declare as a recession.

Interest rates are expected to remain near current levels. We believe the Fed has finished with their rate hikes and that slower economic growth will limit the rise in long-term rates.

Questions?  Email: CompassReport@cavusecurities.com

Economic growth topped expectations during the first half of 2023, with real GDP likely averaging around a 2% pace and employers adding 1.67 million jobs during the first six months of the year. The stronger-than-expected showing has led some forecasters to pull back their calls for a recession, although more than 60% of professional forecasters, including us, still call for the economy to slip into a modest recession later this year or in early 2024.

Expectations for a recession increased substantially about a year ago, once it became apparent reducing inflation would likely be more problematic and require a much more aggressive monetary policy response. After hiking the federal funds rate a quarter percentage point (25 bp) at its March 2022 meeting, the Fed followed with hikes of 50 bp at its May meeting and 75 bp hikes at each of the next 4 meetings. The Fed dialed back to a 50 bp hike in December and raised rates by 25 bp at its first 3 meetings this year before leaving its federal funds rate target unchanged at its June meeting. We expect the Fed to boost the funds rate another 25 bp at its July 26 meeting, which may mark the last hike of this cycle.

So far, the economy has handled the Fed’s rate hikes remarkably well. The unemployment rate, which is currently 3.6%, is 0.2 percentage points lower than it was when the Fed began to raise interest rates in March 2023. The labor market has loosened up, however, with the number of job openings falling modestly and the pace of nonfarm employment growth decelerating from 561 jobs per month in the first quarter of 2022 to just 244 jobs per month over the past three months. The breadth of job gains has also narrowed, as parts of the economy have been more significantly impacted by rising interest rates.

The labor market’s resilience is a big reason why so much doubt has arisen about a recession. The employment data have historically been the most timely and accurate indicator the National Bureau of Economic Research (NBER) utilizes to help decide when a recession begins. Nonfarm payrolls have been highly correlated with the onset of a recession, often falling in the first month of a downturn. The unemployment rate has typically risen slightly ahead of a recession and an increase of 0.4 percentage points or more has nearly always marked the onset of an economic downturn.

The NBER defines a recession as a significant decline in economic activity spread across the economy that lasts more than a few months. The NBER weighs three criteria – depth, diffusion, and duration – to determine whether a decline in economic activity has been ‘significant’. The weight of these criteria depends on the circumstances. The recession triggered by the pandemic was unusually short, lasting just 2 months, but was extremely deep and broad-based.

The U.S. has endured 11 recessions since 1950.  If you exclude the short pandemic downturn, recessions have lasted for an average of 11 months and have seen real GDP decline 2.1% from peak to trough. The 2007-2009 recession resulting from the Global Financial Crisis was the longest, lasting 18 months.

The NBER analyzes a variety of economy-wide measures of economic activity to identify business cycle peaks, including real personal income less transfer payments, nonfarm payrolls, real personal consumption expenditures, wholesale and retail sales adjusted for price changes, and industrial production.

Both nonfarm payrolls and the household measure of employment continue to grow solidly. Most other key indicators the NBER follows have either slowed or contracted slightly. Real personal income and transfers have come close to stalling this past year but have improved in recent months, while inflation-adjusted retail sales have fallen 2.4% over the past year. Inflation-adjusted sales of manufacturers and wholesalers have fallen for the past 3 months and have risen just 0.3% over the past year. And industrial production is up just 0.2% over the past year.

There are plenty of other warning signs. The Conference Board’s Leading Economic Index (LEI) has declined for 14 months in a row and is currently down 8% year-to-year. The LEI is designed to predict the Coincident Indicator Index, which includes four of the NBER’s six series. As such, the LEI has a good track record of predicting recessions, particularly when it has declined this persistently and by such a large magnitude – duration and depth. The decline has also been broad-based – meeting the dispersion test.

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The LEI is designed to predict economic conditions six months out and the most recent string of declines would be consistent with the economy falling into recession during the second half of this year.

Measures of both real economic activity and financial conditions have contributed to the pullback in the LEI, with the ISM-Manufacturing new orders index and consumer sentiment both falling sharply. The spread between the 10-Year Treasury Note and the 3-Month T- Bill, which has been negative for the past 8 months, is another major contributor, as is the Conference Board’s measure of tightening credit conditions.

An alternative and more widely followed measure of the yield spread is the spread between the 10-Year Treasury Bond and 2-Year Treasury Note. That spread turned negative 13 months ago and has remained negative longer and fallen lower than any time since the early 1980s. Negative yield curves have been a reliable harbinger of recessions, with a negative yield curve preceding every recession since the 1970s.

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The lag between when the yield curve inverts and when a recession begins has been between 6 months to 2 years. The average length is about 16 months, which would put the onset of a recession in the third or fourth quarter of this year.  One important sidenote, the extent to which the yield curve is inverted has tended to narrow before a recession began.

The Federal Reserve Bank of New York produces a recession prediction model based off the slope of the yield curve. The most recent data show the risks of recession are already well above levels reached prior to the past three downturns, reaching an eye-popping 67% in June 2024.

The reason an inverted yield curve is such a good predictor of recessions is widely debated. One obvious explanation is an inverted yield curve reflects a rise in risk aversion about the business cycle, leading to less capital spending, lower inventories, and less hiring. A second and related explanation is that an inverted yield makes bank lending less profitable, which leads to tighter credit conditions and fewer loans.

The Leading Economic Index, inverted yield curve, and New York Fed’s recession probability model based off the yield curve make a compelling case that a recession is more likely than not by the middle of next year. That remains our forecast and the forecast for about 60% of professional forecasters that regularly submit economic forecasts to publicly reported media.

While we see a moderate recession as more likely than not, we continue to emphasize it is a close call. Predicting recessions is difficult. The natural tendency of the economy is to grow. Recessions are quite rare. Since 1950, the economy has endured only 113 months of recession. Conversely, the economy grew the other 769 months, or 87% of the time.

There is still a clear path to a soft landing and that case has been getting stronger. Most notably, the inflation data are showing clear signs of moderating, which means the Fed is likely nearly finished hiking interest rates. Moreover, traditional measures of recession risk may be overstating the risk of recession.

The post-pandemic economy has been unusually difficult to read as there have been huge swings in employment, income, consumer spending, and capital investment that have occurred independently of one another. As a result, the economy is currently out of sync relative to most previous business cycles.

Consumer spending, which accounts for two-thirds of real GDP, is a good place to start. Pandemic relief payments enabled consumer spending to rocket back above its pre-pandemic levels just one month after the nationwide lockdown ended. Most of that initial spending burst was on goods. More recently, spending has shifted to services, and spending on goods has slowed or even fallen slightly.

The weakness in goods purchases has led to inventory drawdowns and cut new orders, which are one of the reasons ISM new orders and the LEI have been weak. In fact, the goods sector has been so weak that it has resulted in a ‘freight recession’, with falling shipping volumes and declining shipping rates. Travel and leisure outlays, which are booming by all accounts, do not figure into the LEI nearly as much as goods do.

The emphasis on the goods sector is understandable. Most of the swing in real GDP during economic cycles comes from the goods sector. Spending for consumer durable goods, housing, and business fixed investment typically accounts for most of the decline in real GDP.

While the goods sector has seen some wild swings, the outlook for goods spending does not appear to be anywhere near as dire as the yield curve or LEI suggests.

For starters, light vehicle production is just rising back above its pre-pandemic levels and the supply of new and used cars has improved to the point that sales are rising. There is still substantial pent-up demand for cars and light trucks, although affordability will likely keep a relatively low ceiling on sales. There is also a huge backlog for automotive repairs that will keep body shops busy for months to come.

Home building is another area that is out of sync. The long period of ultra-low interest rates and pandemic-era housing boom resulted in many homeowners locking in generationally low mortgage rates. Sixty percent of outstanding first-lien mortgages are currently below 4%, with 80% below 5%. With such low rates, few homeowners are willing to put their homes on the market, bolstering demand for new homes. With inflation cooling off and the Fed nearly finished raising rates, there is a good chance single-family home building has already seen its lows for this cycle.

We remain concerned about the apartment market. There are more apartments under construction today than at any time since the early 1970s. Apartment starts will likely decline significantly as credit tightens. That will pull overall starts lower. Strength in single-family starts will offset much of this drag, however. The knock-on effects from single-family construction are huge, fueling demand for building products, financial services, furniture, appliances, security systems, lawn care, and all sorts of assorted other items.

There are also reasons to be optimistic about business investment. Demand for capital goods has been surprisingly strong, particularly electrical equipment, commercial aircraft, and heavy trucks. The AI revolution also appears to be kicking off another cycle in IT spending, while the CHIPS Act and Inflation Reduction Act are driving outlays for massive semiconductors plants, EV factories, and battery plants. Construction spending for new manufacturing facilities is running 72% ahead of its year-ago pace.

State and local government is another bright spot that is often overlooked. Pandemic relief to state and local governments helped bolster balance sheets and revenues recovered sooner than expected, leaving many states flush with cash. There has been a recent flurry of water projects around the country. The new infrastructure act will provide a further boost, although public works projects tend to evolve slowly.

While the path to a soft landing appears a little clearer, a recession later this year or early next year is still more likely than not. All the arguments for stronger economic growth are also arguments that inflation will

prove more persistent. Much of the improvement in inflation has come from lower energy prices and fewer shortages in the auto sector. Inflation remains sticky in labor-intensive parts of the service sector.

Wage pressures may intensify further as the tight labor market emboldens workers to demand larger pay gains. The expanding Hollywood writers’ strike might foreshadow more challenging labor negotiations at UPS and the United Auto Workers this fall, setting a more inflationary undertone to wages in general.

Questions?  Email: CompassReport@cavusecurities.com