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The Recession: It’s Here

Inflation Prognosis: Lower

Equity investors just endured the worst first six months of any year since 1970. This occurred despite a “Bear Market” rally in May. For the month, the S&P 500 was down -8.4% (see last column of table) as was the Russell 2000, with the Nasdaq down -8.7% and the DJIA -6.7%. All the indexes except the DJIA are in “Bear Markets” (see second from last column).

This isn’t any wonder.  The incoming data has shown significant deterioration and major data revisions have all been to the downside. 

The latest GDP revision for Q1 put the quarter deeper into negative territory at -1.6% (the initial estimate was -1.3% and the first revision was -1.5%). Worse, consumption, which has been the buoyancy for economic growth, was revised down to +1.8% for Q1 from +3.1%. That means a much weaker handoff from Q1 to Q2.  And, given what we are seeing from the high frequency data, it looks very much to us that Q2 GDP growth will also be negative. The NY Fed’s model shows an 80% probability of a Recession, and the Fed’s Atlanta Reserve Bank’s GDPNow model puts Q2 GDP growth at -1%. If that is close, that would be two quarters in a row of negative GDP growth. While the National Bureau of Economic Research (NBER) is the final arbiter of recession start and end dates, the markets’ rule of thumb has always been two consecutive quarterly negative GDP growth prints. Thus, our view for the past few months (as discussed in this blog), that we were likely already in Recession, appears to be on the cusp of validation.

The Changing Narrative

Until mid-June, the financial markets were all about “Inflation, Inflation, Inflation.” Much of the everyday media still is.  But, in mid-June, financial markets began to worry more about Recession than about Inflation. The chart above shows the peak in the 10-Yr Treasury Note yield at 3.48% on June 13. It closed Friday (July 1) at 2.89%, indicating that markets no longer think the Fed will enact the number and magnitude of rate hikes implied by its “forward guidance,” i.e., the latest “dot-plot.”

The Futures Market tells a similar story. On June 15, the implied Federal Funds Rate (the rate banks borrow and lend their excess reserves to each other overnight) for February 1, 2023, was 3.71%. On July 1, it had fallen to 3.34%, and 2.61% is currently the view for June 30, 2023. 

There are very good reasons for this behavior in the bond and futures markets:

  • The economic outlook for business has rapidly deteriorated. The chart below is from the Philadelphia Fed and the data is for that district. Charts from the other regional Feds look similar.  Note that the six-month forecast for new orders shows the lowest outlook on the chart (that’s since 2002). 
  • The next chart from the National Federation of Independent Businesses (NFIB) shows the worst outlook for small businesses since at least 1990.
  • The University of Michigan’s overall Consumer Sentiment Index, which we have discussed many times over the past few months, appears to be a very good leading indicator of future consumer spending. It is now at the lowest level in its history (back to the 1940s).
  • There appears to be good reason why this index shows so much despair. We haven’t seen this level of inflation for about four decades.  Thus, the majority of consumers have never had to deal with it.  And, it also appears that the real level of inflation is much higher than the CPI implies. The fact is, even with rising wages, consumers have fallen way behind.  Real average weekly earnings (i.e., adjusted for “official” inflation) have fallen -3.5% over the past year. Whenever that has happened in the past, a recession has ensued. This time is no different.
  • In fact, consumers have tried to maintain their living standards by borrowing on their credit cards.  Think of it this way: if a consumer normally fills the gas tank using a credit card, but now it costs $100 instead of $60, the amount of credit usage just went up $40.  Credit cards are now used for food and most other consumption.  Note on the chart the rising revolving credit balances.  Sooner or later limits are reached. 
  • It isn’t surprising, then, that Americans are or plan to cut back on their consumption.  Gasoline volume sales (number of gallons), the first week of June were down -8.2% Y/Y (and down 14 weeks in a row). A recent survey (GoBankingRates.com) of a sample of 2,357 between April 11 and June 21 showed 38% of Americans intend to cut back on dining out, 16% will travel less, 13% will spend less on groceries, and 10% will spend less on gasoline. Only 18% said they haven’t cut back!


Housing, including new homes and the furniture, appliances, carpets etc. that go into them, are a very important piece of GDP.  New home sales, existing home sales, housing starts, and permits to build are all falling.  Mortgage applications for purchase are down double digits, and refis have tanked -75% Y/Y.  Housing starts are at their lowest level in a year, and homebuilder sentiment is at a two year low as mortgage rates have skyrocketed – the S&P Homebuilder Equity Index is down nearly twice that of the S&P 500 as a whole.

Financial Markets Just Catching-Up

The Citigroup Economic Surprise Index tracks whether the incoming data are over, at, or below the consensus Wall Street view. As can be seen from the chart, the data have been consistently “surprising” to the downside, i.e., below consensus expectations.

This means that the financial community has consistently forecast or expected incoming data to be better than what has occurred, i.e., they haven’t yet recognized the weakening economy.  As noted, the bond market seems to have gotten a whiff of that reality.  Here it is in a few bullet points:

  • Consumers spent their stimulus checks.
  • The rise in prices faster than incomes caused the savings rate to plummet.
  • The rapid rise in interest rates has discouraged home refinancing which, as noted, has fallen -75% Y/Y (cash from refis are often used to purchase big ticket items like autos, home improvement, expensive vacations…).
  • With real incomes falling, the consumer has borrowed on their credit cards to maintain lifestyle.

Something Positive – Inflation Will Be Falling

If you’ve read this far, you are probably convinced that the outlook is the worst it has been since at least just prior to the Great Recession or the bursting of the Dot.Com Bubble. And, that’s true. But, there is something positive brewing, and it is the reason why the bond market has recently reacted positively (falling rates). (As an aside: The bond market always moves before the stock market!)

The good news is that inflation will soon begin to fall, both because it always was “transient” (just taking longer) and because the Fed has hit the brakes hard.

  • We are seeing some cracks developing in home prices (finally!).  A June 18 headline from the Advisers Perspectives publication read: Builders Are Slashing Prices to Sell Homes in Fast-Cooling U.S. Markets. The article went on to say that both Compass and Redfin (real estate brokerages) are slashing jobs.
  • In Phoenix, 22% of new listings had price cuts between May 9 and June 5.
  • In Dallas, there is 10.7 months of homes under construction; that’s twice normal.
  • Commodity prices, which rose rapidly due to supply chain issues caused by the pandemic, have rolled over (bigtime).  The prices are from June 23:
    • Copper: -24%
    • Oil: – 15%
    • Natural Gas: -33%
    • Aluminum: – 36%
    • Nickel: -50%
    • Lumber: -57%

And the Baltic Dry Index (average prices paid for transporting dry bulk goods): -58%.

  • As for the supply chain:
    • Freight rates from China to the U.S. are down -34% YTD and -50% Y/Y;
    • The number of ships waiting at the LA and Long Beach ports in CA was 22 in mid-June.  It was 109 a year earlier.
    • In-bound containers at the 10 largest U.S. ports were down -25% Y/Y (May data).
  • Using the average of five Regional Fed Manufacturing Surveys, the chart below shows faster supplier deliveries and rapidly falling order backlogs, both of which indicate a significant easing of supply chain bottlenecks which have played a major role in today’s inflation data.
  • Rental rate increases have been slowing and the national vacancy rate is now rising as a plethora of newly built multi-family units have begun to come to market.  We look for rents to stabilize, if not fall, over the next few months.
  • Consumers are revolting against rising prices (the “cure” for high prices is high prices).  In mid-June, gasoline sales volumes were down -8.2% Y/Y and were down 14 weeks in a row.

Final Thoughts

Incoming data show some of the most dramatic retrenchments we’ve seen since the Great Recession, if not in some of our lifetimes. The question isn’t whether or not we will have a Recession (it appears to be already here), but its depth and duration.  The incoming data says it won’t be mild. And the question of its duration depends on the response of monetary policy (i.e., the Fed). 

In public statements, FOMC (Federal Open Market Committee – the rate setting committee) members have continued with very hawkish rhetoric. But, the Fed’s own NY and Atlanta Regional models say that the Recession has either already begun or is imminent. The Fed employs 400 economists. Among them, they surely see what we see. As noted above, the bond and futures markets have concluded that the Recession will cause the Fed to lower its forward rate guidance. The first sign of that could occur at the July 26-27 Fed meetings. Between now and those meeting dates, there will be a lot more data. Most of it will continue the negative trends discussed above. Key, however, will be the July 13 CPI release of June data. Our view is that June will still be high, but lower than May Y/Y. However, beginning with July’s CPI (released in mid-August), we will see a significant falloff in the Y/Y CPI headline number. Already, the non-Covid inflation data has been behaving, so the easing of the supply chains should help bring down the overall rate of inflation.

The market currently sees a 90% chance of a 75 basis point (.75 pct. point) rise in the Fed Funds rate at the July meetings. If the Fed only raises 50 basis points, that would be the first signal that they see the Recession, recognize that inflation has started to wane, and that the next set of dot-plots (scheduled for the September meetings) will show lower “forward guidance.” If this scenario occurs, bond yields will continue to fall (bond prices rise) and there might be some relief for equities (although we sill haven’t yet seen the impact on equity prices of lower analyst earnings estimates due to the Recession).

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)


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