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Interrogating the Soft Landing

In November 2022, Goldman Sachs forecasters went against the grain when they publicly pegged the probability of a 2023 recession at 35 percent, which was much lower than the other investment banks at the time. From the start of the Fed's rate hikes in March 2022, to today, I understand the consensus view to have evolved through three phases:

  • First, high probability of a "hard landing". The Fed raises rates, the economy suffers

  • Second, definite "hard landing". Two consecutive quarters of negative GDP growth, marking a "technical" recession, now all that's left is for unemployment to rise.

  • Third, either a "soft landing" or "no landing at all". Unemployment stays low and the economy keeps on trucking as inflation gradually comes down. Many analysts suspect China's reopening will help boost aggregate demand

Several data points are helping to give this outlook a boost. For one, the headline unemployment rate is situated about a tenth of a percent less than where it was prior to the Global Lockdown Recession. It is 3.4 now, compared to 3.5 in late 2019. In the same vein, the number of new jobs created each month, as told by the monthly nonfarm payroll report, continues to appear strong.

Source: Bureau of Labor Statistics, Federal Reserve Bank of St. Louis

Of course, there are problems with both of these stats. Persistently low labor force participation would hold down the unemployment rate. In December, the Philadelphia Fed published research estimating net job creation in 2022 to be just 10,500, compared to the Labor Department's 1.047 million. That said, there have been issues with these data for decades, and recessions have still created enough unemployment to override those issues. After those two negative quarters of growth in Gross Domestic Product (GDP), the cumulative growth for the year was 1.0 percent. In other words, slow, but positive. On February 8th, the Federal Reserve Bank of Atlanta updated its GDP "Nowcast" to predict a 2.2 percent annualized growth rate for the three months ending March 31. That's the percent change from first quarter 2022 to first quarter 2023.

The consensus of economic forecasters (blue line) is still slightly negative.

Source: Federal Reserve Bank of Atlanta

Is it time for the bears to be proven wrong? Is it time to declare the US Treasury Yield Curve, which has a 100 percent track record of inverting prior to a recession and is inverted now, a dead indicator?

Unfortunately, recessions do not come with sirens or train horns. The indicators that define them - like unemployment, personal consumption expenditures, and industrial production - are often revised months after initial release. It's not obvious when a recession is forming, and is even less obvious beforehand.

While it would be terrible for Finance and Econ nerds around the globe if the yield curve indicator were declared dead, I would be pleased to see it proven wrong this time. There is one positive aspect to a recession, and only one. They are like wild fires in a forest managed by nature (and not the US forest service). They clear the buildup of dry underbrush that accumulates during a credit boom: the allocation of scarce resources to sub-optimal uses over the course of the expansion phase of the cycle. Unemployment sucks, but if there is too much valuable time and energy being poured into a sector in which it is not generating enough value to cover that cost, the quickest way for that labor to create value elsewhere is often a mass layoff.

But that is the only positive aspect, and frankly, it's only positive in an academic sense. An unemployment rate of 10 percent means that if I know 100 working age people, 10 of them could fall on hard times, and I could be among the ten. That's not a nice reality to live in. All that said, we should meet the "no recession" outlook with suspicion. History can be a useful guide.

Source: New York Times Archive

The 2008 recession began in the first quarter of that year, with an uptick in unemployment and a decline in GDP. In August 2007, the NYT reported on several GDP forecasts from Wall Street and the government.

"Where the [Congressional] Budget Office predicted on Thursday that the economy would pick up speed early next year and expand by 2.9 percent during 2008, many private sector analysts said they see growth of less than 2.5 percent next year, with some going lower."

The growth forecast, among both the CBO and the Street, was higher than the Atlanta Fed's GDP Nowcast, and the current "Bluechip Consensus". By the way, the "Nowcast" has an average error of 0.82 percent in the positive direction, meaning that on average, the Atlanta Fed predicts that GDP growth will be 0.82 percent higher than it ends up being when the data comes out. Unfortunately, the Nowcast wasn't developed until 2011, but I pulled the Wall Street Journal Surveys of Economic Forecasters from around that time.

Source: The Wall Street Journal

In December 2007, among 54 professional economists, there was not a single negative GDP forecast for 2008, and the average growth rate expected for the year was +2.2 percent. In March 2008, three months into the recession, forecasters expected that GDP growth would bottom at +0.1 percent that quarter, and rise enough thereafter for a year end growth rate of 1.2 percent. If one could quantify the words "soft landing" into a GDP forecast, this is exactly what it would look like.

In summary, recent positive data points do not rule out a recession in 2023, and this is not the first rodeo we have seen. Whether a soft landing comes to pass, or a recession awaits, the playbook for households and thereby investors is the same. I am adding some to my rainy day fund, cutting consumption spending (less Starbucks and dining out, enjoying a paid off phone I've had for three years), and holding a larger allocation to cash and money market funds in my investment accounts. In other words, doing all of the things that Keynesians believe are actually the causes of recessions.


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