is another recession coming?

Supply chain disruptions, rising global commodity and energy prices, volatility in major economies and underlying demographic factors have all contributed to rising prices. To manage this, the Federal Reserve has reacted quickly, raising interest rates earlier and more aggressively than any other major economy.

In this paper, Teneo utilizes a combination of modelling, detailed analysis and commentary from highly respected advisers across a range of subjects, including politics, economics and consumer demand, to develop a comprehensive view of how the challenges the U.S. economy faces are likely to evolve in the next 12-18 months. Included are forecasted key macroeconomic factors such as inflation, GDP and employment, and considerations of a wide range of implications for businesses, including consumer spending and behavior patterns, as well as employment, rising inventories and access to credit.

While there is evidence of growth against a backdrop of global uncertainty for the U.S. economy, there remains a very real risk that the U.S. could be about to enter a prolonged recessionary period.

The U.S. government is currently trying to navigate its economy through a challenging inflationary period and orchestrate an outcome that has never been achieved. In other words, manage the dual challenges that rising inflation and rising interest rates have on economic growth while avoiding a recession and achieving its fabled soft landing.

Positive indicators point to its achievability – inflation is down, the labor market remains strong. Despite evidence of declining real wages, this has not yet translated into declines in household consumption. The line between a soft landing and a recession is thin. Consumer confidence is at record lows, and the U.S. is seeing the biggest real wage declines in the wealthiest income brackets, which make up the majority of consumption.

In this paper, we outline four potential economic scenarios for the U.S. going forwards; from a soft landing to the risk of long-term inflation and a deep recession.

While there is cause to be optimistic about the U.S. economy, there remains a significant macroeconomic uncertainty, with the very real possibility that the economy could be about to enter a deep and lengthy recession.

Source(s): Teneo Research & Analysis

Note:1Levels of Inflation forecast for December 2023, 2Interest rate outlook as of December 2023, 3Annual GDP growth outlook for 2023, 4Following the commencement of the recession

Where the U.S. lands within this range of outcomes depends materially on how quickly inflation returns to target levels. Prolonged high inflation will have a substantial impact on consumption, which could tip the U.S. into a recession.

The U.S. is currently facing a period of intense inflationary challenge, with the highest rates of consumer price rises in over 40 years and interest rates rising steeply.

A confluence of factors, including the aftermath of the supply chain disruptions and costs relating to the COVID-19 pandemic, underlying demographic challenges and the ongoing impacts of the Russia-Ukraine conflict on energy and commodity prices, have driven U.S. inflation to a 40-year high.

There have been significant increases in energy prices driven by the Russia- Ukraine conflict and subsequent sanctions. Fuel oil prices increased by 65.7% in the 12 months to November 2022.

The Russia-Ukraine conflict, along with supply chain issues caused by COVID-19, has created shortages and rising commodity prices.

In 2022, the average wheat price was 35% higher than in 2021.

Following COVID-19, there was an unwinding of pent-up demand in the form of delayed purchases. This increased demand and prices for many goods and services as U.S. households spent from their $2.1 trillion excess savings accumulated during the pandemic.

A tight labor market, caused by a shortage of workers and cultural shifts in the workplace, has meant that businesses have had to increase wages to retain and/or hire workers. To accommodate this increase in wage cost, businesses are forced to raise prices, thereby contributing to inflation.

Source(s): JP Morgan Asset Management, Macrotrends, Teneo Research & Analysis

To control inflation and bring it back down towards the U.S. government’s target, the Fed has begun raising its fund rate. While raising the fund rate helps to lower inflation, it also slows the economy down and dampens growth.

Source(s): JP Morgan Asset Management, Macrotrends, Teneo Research & Analysis

Note:1The Federal Reserve increased the fund rate further on the 1st February 2023, to an effective rate of 4.58%. This sits outside the time series shown on the graph

High inflation and rising interest rates are translating into negative headwinds across leading consumer and business indicators, putting the U.S. at a growing risk of recession.

With price increases outpacing wage growth and resulting in declining real wages, consumers are seeing their household budgets squeezed. As household incomes fall in real terms and consumers have less money to spend, there is already growing evidence of negative headwinds across leading indicators of business output and household consumption in the U.S. Taken together, these indicators are linked to a slowdown in GDP.

Consumer confidence has deteriorated against a backdrop of declining real disposable income. Consumer confidence is currently lower than at any point during the COVID-19 pandemic and the Global Financial Crisis.

The net profit margins for the S&P 500 have declined for five consecutive quarters, from 13% in Q2 2021 to 12% in Q3 2022.

Business confidence has declined YoY, with current levels reminiscent of those seen during the U.S.-China trade war in 2019; however, it is still higher than the levels seen during the GFC.

Business inventories have been rising throughout 2022 and were 16.5% higher in October 2022 compared to 12 months prior. This is indicative of slowing demand and a worsening cash position for businesses.

Source(s): BLS, Reuters, Factset, Teneo Research & Analysis

While the U.S. is seeing an economic slowdown with a recession as a very real possibility, there are diverging views on what the economic outlook looks like for the next 12-18 months.

There is broad consensus that the U.S. is likely to see an economic slowdown in Q1 2023 as the impacts of the Federal rate rises from late 2022 start to feed into the economy; however, there is a significant divergence with regards to the quarters that follow.

In a best-case scenario, the U.S. will likely see a ‘soft landing’ with low/slow growth across 2023 before picking up in 2024. However, a downside scenario is a real possibility and could see the U.S. enter a prolonged recession lasting well into 2024, as is currently forecast for the UK and Germany. Over the following pages, we assess the different scenarios that are likely to dictate where the U.S. economy lands within these ranges.

Actual GDP growth will likely be dictated by a small number of key factors.

To understand how these factors will affect the overall outlook, we outline four potential scenarios and consider how key macroeconomic metrics would look in each scenario.

The speed and the extent to which inflation returns to pre-2021 levels depend on a number of key factors. In all scenarios, we expect to see a material softening of inflation in 2023, returning to target inflation levels of 2% by 2024 in the case of a ‘soft landing.’

Integral to the economic outlook over the next 12-18 months is how quickly inflation returns to pre-crisis levels. Inflation will naturally fall across 2023 as prices are compared to the already high levels seen in 2022. Furthermore, with the Fed raising interest rates earlier and more aggressively than other geographies, it hopes to return to the target levels of 2% by 2024.

However, there are several headwinds facing the U.S. that may result in medium to long-term inflation remaining high, and it is not a given that the U.S. will continue to see the low levels it has seen historically.

Fed Response: Raising interest rates increases the cost of borrowing, which in turn impacts demand, putting downward pressure on prices.

The Fed has been proactive in raising interest rates as a response to inflation, with this strategy expected to continue.

Geopolitical Issues: Continued geopolitical turmoil in Europe, as well as COVID-19 outbreaks in China, could continue to disrupt the supply chain and create excess demand through shortages, driving prices upwards.

Labor Supply Shortages: There are structural issues in the labor market, which have included inactivity and long-term sickness, which have resulted in skill shortages.

While this lowers the risk of widespread unemployment being triggered by a downturn, it has placed upward pressure on wages, which may drive further inflation.

Interest rates are expected to continue to rise through the first half of 2023 before declining from 2024 onwards.

While consensus appears to be that the Fed is likely to begin lowering interest rates in the second half of the year, there are a number of scenarios in which a significantly different profile may be seen.

If inflation turns out to be harder to unwind than anticipated, the Fed may choose more aggressive rises at the expense of growth. On the other hand, a faster easing of inflation or a more significant slowdown arising from interest rate rises may result in earlier lowering.

Inflation proves to be harder to unwind than expected: If inflation remains higher for longer than expected, the Fed may have to increase interest rates further so that long-term inflation expectations can be managed back to the target level.

Inflation returns to target quicker than expected: If inflation starts to show signs of falling in early 2023, the Fed may choose to lower interest rates earlier than expected.

Instability in the labor or housing market: If the housing market or labor market begins to show significant signs of trouble, such as large upticks in unemployment or significant declines in house prices, the Fed may choose to lower rates earlier to encourage growth.

A soft landing or a mild recession could mean real wages start to increase by mid-2023.

How quickly real wages return to growth is critical for the economic outlook and a key driver of consumer spending. Individuals saw declines in real wages across 2022 and, as a result, have begun feeling less well-off than they did 12 months ago. This is further exacerbated as savings accumulated during the pandemic are reduced. In a soft landing scenario, real wages are expected to grow again by early 2023.

However, long-term inflation could see real wages declining throughout 2023 and then remaining static for a prolonged period. It is in this scenario that we would expect to see the greatest impact on consumer spending.

Over the past 12 months, individuals across lower income brackets have seen faster wage growth, reversing historic trends.

The impact of these declines is not evenly distributed, with high-income households being disproportionately impacted by declines and, therefore, more likely to see the largest drops in consumption. This is distinct from what is being observed in other geographies, such as the UK, where wage growth in higher income groups has outpaced lower income groups.

Source(s): BLS, Atlanta Fed, FRED, Teneo Research & Analysis

Note:1Covers 12 month moving average of median wage growth and inflation by income as of November 2022 2Inflation November 2022 3Average income is after taxes and includes all sources of income for 2021

Declines in real wages, coupled with low consumer confidence, are likely to translate into a drop in consumption in the highest income groups.

Real wage declines in the top income brackets are resulting in drops in consumer confidence as households feel less well-off. Consumer confidence is now at lower levels than during the 2008 GFC and the COVID-19 pandemic.

Going forward, this is expected to have a knock-on impact on consumption, with low confidence resulting in households choosing to preserve savings  reduce consumption. Reduced consumption, particularly in high-income groups who make up a significant proportion of overall consumer spending, is likely to have a significant impact on outlook and has the potential to tip the economy into a recession.

While the U.S. labor market seems healthy on the surface, there are structural challenges that have the potential to create headwinds in the upcoming 12-18 months.

The U.S. labor market, on the whole, appears strong. Low levels of unemployment and high amounts of open positions mean that although unemployment is likely to increase as a result of interest rate rises, the general consensus is that this softening in the labor market will be modest. Even in worst case or more pessimistic forecasts, unemployment is only set to rise to 5%, well below the levels seen during the GFC. However, while unemployment may not rise significantly, structural challenges in the labor market, including low participation and high levels of long-term sickness, are creating supply challenges that may put further pressure on inflation.

Low participation rates: Over the last 20 years, the labor force participation rates in the U.S. have been declining from an all-time high of 67.3% in January 2000 to 62.1% in November 2022, resulting in labor shortages.

High levels of long-term sickness: U.S. life expectancy has declined by 0.6 years in the period from 2010 to 2022; 78.8 in 2010 to 78.2 in 2022.

In Europe, the increase over the same period has been 1.4 years to 82.1 in 2022.

Rising chronic health problems mean that workers are less productive and absenteeism increases, thus reducing economic output.

In fact, the CDC estimates that six in ten adults in the United States live with a chronic disease.

Cultural shifts: Following the pandemic, 38% of workers looking for a new job were doing so because of work-life balance challenges.

Since certain job roles are limited by the type of flexibility they can offer, certain sectors will likely face labor shortages as workers transition to alternative careers.

Sources: United Nations, Prudential, Statista, Teneo Research & Analysis

Note:1Not seasonally adjusted

Supply-side shortages created by structural challenges in the labor market could lead to further wage pressure and drive up inflation as a result.

While low levels of unemployment and high amounts of open positions today generally point to a strong labor market, this is a dynamic primarily driven by supply-side shortages rather than strong growth in business output. These supply-side shortages are creating upwards pressure on wages. While this wage growth has helped individuals partially cover the cost of rising inflation, it can also be a driver of further inflation.

Changes to interest rates, inflation and suppressed consumer demand will have a direct impact on business output.

Any reductions in consumer spending are expected to acutely impact discretionary consumer-facing industries, as individuals re-prioritize spending as household income declines.

Evidence from the 2008 GFC is informative regarding where consumers may cut back. For instance, between 2006 and 2010, U.S. consumers materially adjusted their proportional household spend in order to prioritize certain goods and services over others. However, today’s environment is different in several ways.

Greater competition for spend: There are a number of goods which were previously considered discretionary but are now considered essential and therefore are fighting for a wallet share, including broadband, mobile telephone and streaming services.

Latent demand for unavailable COVID-19 activities: Consumers have been prevented from travel and tourism activities. There is evidence that consumers are looking to travel more and prioritize that spend. In 2022, 60% of travellers planned on visiting a new desitination1. This makes it likely that consumers trade down in other areas of expenditure categories.

Source(s): Labor Turnover Survey (US Bureau of Labor Statistics); Morgan Stanley; CNN Business, OAG, Teneo Research & Analysis

Note:1Results from a survey in April and May 2022 via OAG’s flight tracking app

Beyond a reduction in spending, consumers are also more likely to ‘trade-down’ their current spending for cheaper alternatives.

Retailers that can demonstrate value for money are likely to win over trade-down customers.

Signs of ‘trade-down’ behavior are emerging, with a consumer survey from September 2022 indicating that 70% of respondents indicated they were trading down3.

In the event of persistently high inflation and low growth, it is likely that consumers will continue to ‘trade-down’ throughout 2023 to offset reduced real incomes.

For businesses to retain customers and protect against trade-down behavior, they need to be competing on the value for money they provide – offers and loyalty will become increasingly important.

Resale market growth: Increasingly environmentally aware consumers will look to save money by purchasing second-hand. The secondhand fashion market is set to grow by 26% across 20232.

Source(s): 3US Consumer Pulse Survey (Morgan Stanley); 2thredUP, Teneo Research & Analysis

Note:1Luxury segment tends to trend more regional than national, 2Corporate identifies discount stores separately to supercenters

Interest rate rises have had a major impact on the housing market with mortgage rates doubling in the last 12 months, resulting in steep declines in activity and falls in house prices.

Source(s): FRED Economic Data, Mortgage Bankers Association of America, Freddie Mac, Teneo Research & Analysis

Note:1Calculated using the average mortgage value of a house: $387,600 (Dec 2022) multiplied by the Avg. 30 year mortgage rate 2Forecast from Case-Shiller survey of 25 house pricing strategists

Though initial warning signs are there, the industrial and manufacturing sector is likely to be more insulated than other industries due to pent-up demand, offsetting price pressure.

PMI is a leading indicator, calculated using survey responses from purchasing managers in the U.S. economy, that gauges the outlook for the manufacturing sector based on five key components.

In the manufacturing sector, downward pressures are coming from a lapse in new orders, production and supplier deliveries. Additionally, inflation pressure is driving up costs, though this is expected to lessen for 2023.

That being said, employment is expanding, and though inventory levels are unusually high, the risk of write-off is limited, largely due to products waiting on components for completion and companies holding higher a safety stock of key raw materials. Additionally, a backlog of orders is supporting growth.

Sources: ISM PMI, Teneo Research & Analysis

Aerospace and aviation are highly cyclical businesses and are heavily connected to the state of the economy.

Cyclicality with GDP Growth: Airline profit cycles closely follow that of the economy, as aviation demand is primarily a consumption-led phenomenon – in 2009, at the height of the GFC, air traffic dropped 6.1%.

Lagged recoveries: Passenger numbers generally lag behind the recovery in industrial output due to reliance on employment and household incomes; this lag is exacerbated further for ‘premium’ class travel as opposed to ‘economy’ class.

Freight often recovers before passenger travel: As freight is linked inextricably to industrial output, and is typically a preferred mode of transport for shipping due to its low transit times, it often recovers first –during the GFC, freight began recovery four months before world trade and two months before industrial production.

Source(s): US Department of Transportation; (Franke and John, 2011) What comes next after recession? – Airline industry scenarios and potential end games, Teneo Research & Analysis

Aviation and aerospace players should see the looming recession as a considerable headwind.

Private equity houses have become accustomed to operating in low-interest rate and low-inflationary environments. The highly leveraged nature of this industry poses potential risks to the sector going forward.

Amid increasing interest rates, investors fail to see the value in technology stocks as the path to growth is unclear.

Previous U.S. slowdowns and recessions can inform the likely outlook of the next 12-18 months.

Businesses should seek to prepare for a prolonged high interest rate environment, unlike previous recessions.

Compared to Europe, the outlook for the U.S.’s GDP growth in 2023 has improved in recent months due to stronger economic performance.

For the majority of 2022, U.S. growth in 2023 was forecasted to be lower than that in Europe. This trend has reversed since Q4 2022. The U.S. is now expected to perform better than Europe throughout 2023 for several key reasons:

Slowcession? Richcession? Or just recession?

Whether in the supermarket aisle, or the corporate suite, a lot of people are expecting a recession – even if there's no certainty there will be one at all.

Survey after survey shows fears of recession are high. It's easy to see why.

The Federal Reserve is increasing interest rates in the most aggressive fashion since the early 1980s as it races to bring down inflation. And a recession is often the consequence when the central bank starts raising borrowing costs.

The prospect of recession is certainly scary. But even if the U.S. is headed for one, it's worth keeping in mind that no two recessions are alike.

A recession could be blip-ish, like the short, pandemic-induced one in 2020, or more like the economic tsunami that followed the 2008 housing meltdown.

So, from recession with a small r to the so-called soft landing, here are some of the current predictions of what kind of economic slowdown the U.S. could be facing.

In a recent poll of economists, the World Economic Forum found that nearly two-thirds of the respondents believe there will be a recession in 2023.

But here's the good news: Many analysts expect a relatively mild and short recession, or what is sometimes referred to as recession with a small r.

Unlike the early 1980s, when the Fed's steep rate hikes sparked a brutal recession, this time around the economy still appears to be reasonably resilient despite grappling with the highest inflation rate in around 40 years.

A big reason is the health of the labor market. Yes, there have been high-profile layoffs at companies such as Google and Amazon recently. But those announcements were largely about paring back staff after these companies over-hired during the pandemic. In fact, the overall data still shows employers continue to hire.

Employers added 4.5 million jobs last year, marking a pretty spectacular comeback from the depths of the pandemic.

Of course, the Fed's rate hikes will likely lead to some job losses. The Fed in December projected the unemployment rate would rise to 4.6%, from the currently near-record low of 3.5%.

But that still would be a historically low number.

Trying to come up with catchy terms to describe an event is something of a tradition in economics, though they rarely actually catch on, with a few exceptions such as "the Great Resignation" or "skimpflation" (which was coined in this newsletter).

Moody's Analytics is now giving it a try.

"Slowcessation" is a forecast that the economy will undergo a difficult period of almost no growth but will ultimately avoid an actual contraction. It's an argument that others also believe.

In a report laying out its thesis, Moody's argues that the economy still has plenty of things going for it, including healthy household finances, as well as strong corporate balance sheets.

Moody's believes those could help offset the economic consequences of raising interest rates, such as higher borrowing costs, lower economic growth, and more volatile financial markets.

"Under almost any scenario, the economy is set to have a difficult 2023. But inflation is quickly moderating, and the economy's fundamentals are sound," writes Mark Zandi, Moody's chief economist.

"With a bit of luck and some reasonably deft policymaking by the Fed, the economy should avoid an outright downturn. If so, we may dub it a slowcession."

This one was coined by Wall Street Journal columnist Justin Lahart. Yes, journalists also try hard to come up with catchy terms, with a similarly poor track record of success.

"Richcession" refers to a recession or near-recession that impacts the rich more than lower-income folks. That would be unusual because recessions typically hurt the relatively less well-off the most.

Poorer people are already suffering in the current downturn, but Lahart and others say that if we do slip into recession, lower-income workers may find themselves more insulated than in previous recessions.

The labor shortages during the pandemic forced many businesses to boost wages to recruit staff. Wage gains at the bottom of the income scale were proportionately larger than those at the top, although many workers' wage gains were partially eroded by inflation.

Inflation is now easing but the wage gains remain. That factor should help lift the overall net worth of lower income workers as they face a potential recession.

And the most recent labor data shows sectors that typically hire lower-income workers such as leisure and hospitality continued to hire strongly as Americans continued to dine out and take vacations. In fact, retail businesses, still remembering the nightmare of recruiting workers during the pandemic, are more keen to hold onto staff.

That's also raising hope that those with lesser means could be spared some of the impact of an economic downturn.

Of course, there's no certainty the U.S. will have to endure a recession at all.

The Fed has continued to argue it has a path to raise rates without sparking a recession, instead steering the U.S. into what's called "a soft landing" – a scenario in which the economy slows but doesn't contract, and unemployment doesn't spike significantly.

Some recent indicators point toward that more optimistic scenario.

Inflation continues to moderate, with the annual rate falling to 6.5% in December from a peak of 9.1% in June.

Some of the factors that especially worried the Fed are also trending in the right direction, including, most prominently, cooling wage and price increases.

That has allowed the Fed to moderate the size of its rate hikes, and analysts now expect the central bank will raise rates by only a quarter percentage point at its meeting next week.

Furthermore, China's end to its COVID-19 restrictions has raised hopes for a stronger global economy, which can have a positive impact in the U.S. as well. This cuts both ways, though, as increased demand for energy to power China's economy could result in higher oil and gas prices.

In an unpredictable world, no scenario can be ruled out – and neither can the prospect that the Fed's rate hikes will help spark a tough recession, or a hard landing in economic lingo.

For one, the Fed could overdo the rate hikes, raising them more than necessary. Managing interest rates is an inexact science and mistakes can be dire. The Fed was widely blamed for keeping rates too low in the lead-up to the 2008 Global Financial Crisis, for example.

Meanwhile, Russia's invasion of Ukraine continues to weigh on the global economy. Nobody can predict how the war there will ultimately end.

There is another, big potential risk on the horizon: the looming fight over the debt ceiling.

In a recent poll of economists, the World Economic Forum found that nearly two-thirds of the respondents believe there will be a recession in 2023. But here's the good news: Many analysts expect a relatively mild and short recession, or what is sometimes referred to as recession with a small r.

Forecasters have modestly upgraded their outlook for the economy and job market, and they now expect a recession to begin later in 2023 than they had thought.

Fifty-eight percent of the economists still say there’s more than a 50% chance of a downturn in the next 12 months, according to a panel of 48 forecasters surveyed Feb. 3-10 by the National Association of Business Economics (NABE). That’s about the same share as in a December survey.

But just 28% expect the slump to begin in this quarter, compared with 52% who held that view in December. Instead, 33% predict a recession will start in the second quarter and another 21% say it will begin in the third quarter.

A big reason for the improved forecast is January’s stunning 517,000 job gains and drop in the unemployment rate to 3.4%, a 54-year low. The jobs report, announced by the Labor Department early this month, portrayed a more vibrant employment market than had been captured by the steady slowing in monthly payroll gains late last year to a still robust 300,000 or so.

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NABE forecasters now project average monthly employment additions of 256,000 in the current quarter, up from their estimate of 103,000 in December, according to their median forecast.

They also predict average job gains of 102,000 a month for all of 2023, up from 76,000 in December, and unemployment that rises to 4.3% by the fourth quarter, below the 4.5% that had been projected.

Even as they foresee the nation slipping into a mild recession this year, most of the economists believe unemployment could peak at just 4.9% – still a historically low level.

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Interest rates keep rising:Fed hikes rates by 0.25 percentage point to tame inflation

Booming job gains have bolstered Americans’ income and spending, which makes up 70% of economic activity. Consumption jumped 1.8% in January, the Commerce Department said Friday, the largest gain in nearly two years, despite high inflation, rising interest rates and a shrinking reserve of the additional cash U.S. households amassed early in the pandemic.

“I think the economy has proven to be more resilient than many economists expected,” says Ken Simonson, a NABE survey analyst and chief economist of Associated General Contractors, a trade group for the construction industry.

Many experts say low household debt, the pandemic-related savings and the vigorous labor market have helped Americans weather the higher costs of inflation and rising interest rates.

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To be sure, growth is poised to slow as the Federal Reserve’s most aggressive campaign of interest rate hikes since the 1980s – aimed at bringing down inflation – curtails consumer and business spending. Many economists believe the strategy will trigger a recession this year.

But the NABE forecasters expect the economy to grow 0.8% in 2023 – based on the change in average GDP over the four quarters compared with 2022. That is down from 2.1% last year but up from their 0.5% estimate in December.

Inflation generally has fallen briskly in recent months, and the forecasters reckoned the consumer price index would rise 3% in 2023, down from their December estimate of 3.1% and the 6.5% gain recorded last year.

Still, they estimate the Fed’s key interest rate will end 2023 at a range of 4.75% to 5%, above the 4.5% to 4.75% range they previously predicted but below the 5% to 5.25% range projected by Fed officials.

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Just 51% of the economists say excessive Fed hikes pose the biggest risk to the economy, down from 65% in December. A small but growing share now sees a broadening war in Ukraine as the greatest risk.

The NABE survey, however, was taken before recent reports showed inflation rising more than expected in January, a development that could prod the Fed to raise rates more sharply.