ILCB - A U.S. Recession Looks Less Likely This Year - But We Believe The Risks Are Still Elevated
2024-01-25 02:18:00 ET
Summary
- There will be a lot of firsts for the economic history books if this business cycle can survive a labor market slowdown, 525 basis points (bps) of rate hikes and an extremely inverted U.S. Treasury yield curve. But the dovish shift from the U.S. Federal Reserve (Fed) in December makes a soft-landing scenario more likely than a recession, in our view.
- We’ve lowered our U.S. recession probability from 55% to 45%. However, we still see recession risks as higher than normal, given that in a typical year, the normal probability for a recession is 15-20%.
- Sticking a soft landing remains difficult. If the Fed cuts rates too much, economic growth and inflation could reaccelerate. If the Fed cuts rates too little, the U.S. economy could still fall over into recession.
- We believe U.S. equities remain expensive and directionally overbought, and that consensus earnings expectations still look too optimistic. For U.S. rates, the combination of lower yields in Q4 and our new recession probabilities narrows the valuation opportunity in Treasuries somewhat.
Overview
As a general principle, we tend to think an economy’s recession risk is lower when it has spare capacity and higher when it is overheated. The reasons for this are twofold:
- 1. Overheated economies generate more inflation. Inflation forces authorities to implement restrictive policies to slow down aggregate demand. Recessions can be a desired or accidental result of this adjustment process.
- 2. Overheated economies tend to have more imbalances and vulnerabilities (e.g., overinvestment in 2000 created a capital overhang, consumer and banking system leverage in 2007 created well-known market failures and saddled the economy with years of deleveraging). Imbalances increase fragility and amplify the slowdown in economic growth.