Economic Commentary - Is the US on the brink of recession?

Concern that the US economy could be heading into recession prompted a bout of market volatility at the start of August. In this month’s commentary our Chief Economist, Colin Warren, assesses the risk of recession in the world’s largest economy.

Since the pandemic, the general impression of the US economy has been one of resilience, as economic growth has been solid despite the Federal Reserve implementing the sharpest monetary tightening in decades. However, concerns that the economy could be headed for a recession rose sharply at the beginning of August, prompting sharp falls in equity markets and other risky assets. In this month’s commentary, we look at whether such fears are warranted and assess the potential risks going forward.

Why are investors worried?

Investors have been on the lookout for signs of economic weakness ever since the Fed started hiking interest rates to rein in inflation back in March 2022. Expectations of a pending downturn were heightened following an inversion of the yield curve (a development that has historically taken place 6-24 months prior to the onset of recession – see our commentary of April 2022¹) in April 2022². As it turned out, the economy has held up better than most observers were expecting, as excess savings built up during the pandemic bolstered household finances, and loose fiscal policy boosted economic activity (see our Commentary of December 2023³).

However, another recession signal is now flashing red. Labour market data for July showed the economy creating a lower-than-expected 114,000 jobs and the unemployment rate rising to 4.3%, its highest since September 2021⁴. In particular, the rise in the unemployment rate has triggered the so-called Sahm rule recession indicator, that stipulates that the economy has fallen into recession when the three-month moving average of the unemployment rate rises half a percentage point above its low from the previous 12 months. Worryingly, the indicator has never been wrong going back to the early 1970s⁵.

Nevertheless, in the same way that the yield curve inversion has sent a misleading recession signal (at least within the timescales seen historically), the Sahm indicator might also be sounding a false alarm. For a start, part of the weakness in the July labour market data might be the result of disruptions due to adverse weather, notably the impact of Hurricane Beryl. Moreover, the rule’s inventor, former Fed economist Claudia Sahm, thinks the economy is not currently in recession, because the rise in the unemployment rate has been partly due to more workers coming into the labour force (a result of increased immigration and other factors) rather than mass layoffs⁶.

Recessions in the US are quite specifically defined. The National Bureau of Economic Research's (NBER) Business Cycle Dating Committee sees a recession as a “significant decline in economic activity that lasts more than a few months and is spread across the economy”⁷. However, judging by the more widely accepted definition – i.e. when a country’s Gross Domestic Product (GDP) falls for two or more consecutive quarters – the US is unlikely to currently be in a recession. Real GDP expanded at a seasonally-adjusted annualised rate of 2.8% in the second quarter following a 1.4% expansion in the first⁸. And following the publication of a range of monthly indicators for July (including strong retail sales figures, but weak housing market data), the Atlanta Fed GDPNow model sees third quarter growth tracking an annualised pace of 2.0%⁹.

A cooling labour market

At this stage the US labour market appears to be cooling (or ‘normalising’ in the words of Fed Chair Jerome Powell) rather than cracking. Unfilled job vacancies have fallen back from the highs seen in 2022, but are still above pre-pandemic levels¹⁰. Weekly initial claims for unemployment benefit ticked higher in July, but have fallen back in recent weeks and are below recession-like levels¹¹. There have been some high-profile job cuts announced in recent months, particularly in the tech sector from the likes of Intel and Cisco Systems, and there are understandable concerns that the adoption of artificial intelligence (AI) could lead to widespread job losses. However, whole economy job layoffs reported in July by the Challenger Report were relatively low at 25,885, and year-to-date job cuts are running below 2023 levels¹².

Although the jobs market data might not be consistent with an imminent recession, some trends suggest that the risk of a downturn is rising. Companies that are experiencing reduced demand are likely to let temporary workers go before firing permanent staff, and historically, the number of workers employed on temporary contracts has fallen prior to recession. This trend has been seen in the US for over 2 years now; the number of workers in the temporary help services category stood at 2.71 million in July, down from a peak of 3.18 million in March 2022¹³.

Consumer Stress

Optimism that a recession will be avoided in part stems from the fact that US households – which account for roughly two-thirds of spending in the economy¹⁴ - are in pretty good shape. With inflation having fallen back, wages are now rising in real terms¹⁵. Importantly, consumers have not overextended themselves (household debt to GDP stands at around 73%, down from nearly 100% prior to the great financial crisis¹⁶) and with most homeowners having locked in low long-term mortgage rates during the pandemic, debt servicing costs as a share of disposable income are still relatively low¹⁷. Moreover, households that own their own homes and have exposure to the equity market have seen sharp increases in their wealth in the years since the pandemic (recent volatility notwithstanding)¹⁸.

However, less well-off households are struggling. According to estimates from the San Francisco Fed, excess savings balances that were built up during the pandemic, and which in aggregate peaked at US$2.1 trillion in August 2021, have now been depleted¹⁹. Partly as a consequence, signs of stress are starting to emerge. The delinquency rate on credit card loans (i.e. the percentage of accounts that are past due on their required payments) has risen, and stood at a 12-year high of 3.2% in the first quarter of this year. However, while delinquency rates do tend to rise before the onset of recession, they are still historically low (by way of comparison, the delinquency rate on credit cards was nearly 5% prior to the 2008-09 recession)²⁰.

Weak manufacturing, strong services

Looking at GDP from an output perspective, some sectors are doing better than others. Manufacturing has been in the doldrums for most of 2024 (not least as consumers have prioritised spending on experiences such as travel and recreation over physical goods), and survey data suggests that orders and output lurched down further in July²¹. However, manufacturing now only accounts for around 10% of GDP²², and the services sector - which makes up about 70% of GDP²³ - has held up much better, with business activity strengthening in July²⁴.

One area that has suffered disproportionately from high interest rates, and might already be described as in recession, is housing. Soft demand (resulting from elevated house prices and historically high mortgage rates), along with an oversupply of new houses on the market, have prompted a fall in new builds. Single-family housing starts (i.e. the number of new homes construction companies started work on) fell 14% in July to their lowest level since March 2023²⁵. Residential fixed investment (which accounts for around 4% of GDP) contracted at a 1.4% annualised rate in the second quarter²⁶, and with confidence amongst homebuilders deteriorating in August²⁷, there is a good chance that it will fall again in the third, putting the sector in technical recession.

Interest rate relief

However, the housing market (and the broader economy) is starting to get some support from lower long-term interest rates, which have fallen in anticipation of rate cuts from the Fed. The benchmark 30-year mortgage rate currently stands at around 6.5%, its lowest level since May 2023 and down around 70 basis points in the last 3 months or so²⁸. In response, mortgage applications have picked up in recent weeks²⁹.

Lower long-term interest rates are dependent on the Fed following through with expected rate cuts. However, the softer tone of recent real economy data and a fall in core inflation to 3.2% in July (its lowest level in over three years)³⁰, makes it highly likely that the Fed will kick off its easing cycle in September with a cut of at least 25 basis points.

The outlook for interest rates will remain highly dependent on the incoming economic data, but with confidence growing that inflation is being brought under control, policymakers are shifting their focus to preventing a sharp deterioration in the jobs market. Although rate cuts will take time to have an impact (and the Fed has come in for criticism that it has kept rates too high for too long), the good news is that, with the policy rate at a 23-year high of 5.25-5.5%³¹, the Fed has plenty of scope to ease policy.

Recession not imminent, but risks rising

The evidence from the latest earnings season also provides cause for optimism. The earnings per share of S&P500 companies rose an impressive 10.9% y/y during the second quarter, the fastest rate of growth since Q4 of 2021 and ahead of analysts’ expectations³². Indeed, there are signs that profits growth is broadening, with companies other than the so-called Magnificent Seven, mega cap tech stocks (i.e. Apple, Microsoft, Alphabet, Amazon, Meta, Tesla and Nvidia) now reporting stronger earnings³³. Encouragingly, according to Factset, the number of S&P500 companies mentioning the word ‘recession’ on recent earnings calls was just 28, below the 5-year average of 83 and the 10-year average of 60³⁴.

Of course, there is the possibility that recent macro data will be revised downwards. However, as it stands, the evidence suggests that the US economy, while cooling, is not on the brink of recession. This said, there are pockets of weakness (notably in manufacturing and residential construction) that could broaden out. And although in aggregate the household sector looks healthy, some consumers are starting to show signs of stress. For a slowdown not to morph into a recession, the Fed needs to start cutting rates soon so that policy does not become too restrictive in real (i.e. inflation-adjusted) terms. With lower inflation allowing policymakers to increasingly focus on downside risks to activity and employment, the Fed might still pull off the fabled ‘soft-landing’ for the US economy.

Monday 19 August 2024

1 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-what-is-the-yield-curve-and-why-is-it-making-some-investors-nervous/

2 https://fred.stlouisfed.org/series/T10Y2Y

3 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-4-things-we-learnt-about-the-global-economy-in-2023/

4 https://www.reuters.com/markets/us/us-job-growth-misses-expectations-july-unemployment-rate-rises-43-2024-08-02/

5 https://fred.stlouisfed.org/series/SAHMREALTIME

6 https://www.bloomberg.com/opinion/articles/2024-08-07/the-sahm-rule-is-warning-of-recession-but-claudia-sahm-isn-t-sold?sref=QJEHVNWR

7 https://www.nber.org/research/business-cycle-dating

8 https://www.bea.gov/data/gdp/gross-domestic-product

9 https://www.atlantafed.org/cqer/research/gdpnow

10 https://tradingeconomics.com/united-states/job-offers

11 https://fred.stlouisfed.org/series/ICSA