As we sit here today, there is no guarantee of a recession. The labor market remains very strong, consumer balance sheets appear solid, and the Federal Reserve has been unanimously optimistic about the prospects for the U.S. economy (perhaps take that last one with a grain of salt).
However, predictions for a recession are becoming louder and more frequent from many market participants and we believe the odds are about 50/50 that the U.S. economy enters a recession sometime in 2023 (if not sooner). To combat inflation, the Fed has charted a course to increase the benchmark Federal Funds Rate above their estimated neutral rate. Increasing the Fed Funds Rate above “neutral” has a slowing effect on the economy with the goal of dampening inflation.
Balancing the need to fight inflation with the desire to keep the economy growing is very hard. In fact, there has only been one instance when the Fed raised rates above neutral and did not cause a recession (1994-95). The chart below illustrates the market’s expectation of that reality. The market believes the Federal Reserve will be forced to cutinterest rates towards the back half of 2023 in response to, presumably, a recession. Rate cut expectations alone do not ensure a recession but combined with rapidly declining consumer confidence and a magnitude of rate cut expectations only matched by the period prior to the Great Financial Crisis, we believe all signals point to a substantive probability of the economy contracting.
Investors should take comfort in the fact that just because the chance of a recession is higher than normal, it doesn’t mean the contraction needs to be crisis-like. Given the experiences in 2008 and 2020, we have become conditioned to believe that recession equals catastrophe. Recessions can also be mild, and although we believe the market may struggle for some time, some of the economic risk we face is already reflected in stock prices.
Market Expectations for the Federal Funds Rate
(4 Rate Cuts Expected Between 2023-24)
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