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Saturday, Feb 24, 2024

The Case for a Recession in 2023

At Chapman University’s 45th annual forecast conference last December, we forecasted a mild recession would occur this year. That forecast seems to fly in the face of the recent report that top-line real GDP grew at a solid 2.9%, but digging a little deeper into that report suggests that storm clouds are forming.

As shown in Chart 1, real residential investment on a year-to-year basis dropped almost 20% in the fourth quarter. That’s one of the surest signs of a future economic downturn. Because of the reliance of many consumer products and financial services sectors on housing, lower residential investment eventually hits a large swath of the macroeconomy.

Chart 2 shows that the economy six months prior to the 1974-75 recession looked uncannily like it looks today. While real GDP was growing at a steady positive rate, residential investment was dropping sharply. The contagion of this decline eventually led to lower growth in real GDP and a recession that started six months later.

There are other trends that also point to a midyear recession. The recent 25-basis point hike in the Fed funds rate has pushed the Fed’s target range to 4.5%-4.75%. As a result, the spread between the Fed funds rate and the 10-year T-bond rate has turned negative. This shift is significant. As shown in Chart 3, all eight recessions since 1965 occurred after the spread between the 10-year T-bond and Fed funds rate turned negative.

The remarkably consistent pattern between a negative interest rate spread and recessions is not the stuff of sunspot theories. It occurs because the Fed’s actions in increasing the Fed funds rate ultimately lead to lower spending and reduced demand for borrowing. That, in turn, leads long-term interest rates like the 10-year T-bond to stabilize or even decline.

The Fed, however, places upward pressure on the Fed funds rate as it continues its anti-inflationary fight. Eventually, the more rapidly increasing policy driven Fed funds rate moves above market-determined long-term interest rates, thereby leading to a negative spread.

As shown in Chart 4, our forecast calls for slower but continued increases in the Fed funds rate to 5.2%. At the same time, we are forecasting the 10-year T-bond to remain close to its current rate of 3.4%. That’s a negative spread of almost 2%. Such a spread has never occurred without a recession soon following.

In the face of this, what to do … what to do?

Recessions don’t affect everyone the same way, but they almost always lead to rising inventories, rising unemployment and lower consumer spending and industrial production.

Since cyclical troughs in the stock market occur during a recession, careful planning should be done, preferably with a financial adviser, to create a more defensive portfolio. That means pivoting to more cash and a greater share of investments in companies that are more recession-proof, like consumer staples, utilities and healthcare.

Of course, we may be wrong. In spite of the fact it’s never happened before, Jerome Powell and his colleagues on the Fed might be the first to pull off a soft landing. But even if it does, the sharp drop in residential spending that has already occurred means that we’re in for a bumpy ride, one that’s pointing south.

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