Is the US headed for recession?

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A recent weak US jobs report has the market questioning the likelihood of a soft-landing. So this month I’m returning to a question I’ve pondered about more than once since the post-pandemic inflation surge – is a US recession likely?

18 months ago, most of the forecasting community, myself included, expected a US recession. The below chart sums up why – the Federal Reserve (Fed) had just delivered one of the fastest, most aggressive rate hiking cycles in history. When the Fed slams the brakes in this way, a soft landing is incredibly rare, and more commonly the US economy shudders to an uncomfortably abrupt stop. Sometimes it takes weeks for policy to have this effect, sometimes years. These are the long and variable lags that plague the forecasting community.

Instead, the US economy showed extraordinary resilience. US households appeared to have reduced the interest rate sensitivity of the economy by fixing their mortgages for 30-years at low rates. Households also had pent-up savings from the pandemic to burn through while various government programmes (CHIPS Act, JOBS Act, Inflation Reduction Act) meant that fiscal policy was still providing a massive support to growth. But many economists, myself included, have probably remained quietly nervous that the mischievous ‘long and variable’ lags could still spell trouble ahead.

The latest payroll print has challenged the soft-landing thesis. The print garnered so much attention among investors because the rise in unemployment triggered the ‘Sahm rule’.

The Sahm rule, named after its creator Claudia Sahm, tracks how the three-month moving average of the unemployment rate sits relative to the low observed within the last 12 months. Essentially, it’s tracking momentum in the number unemployed. Historically when this measure has reached 0.5% pts, the US has been in, or on the precipice of, recession.

There are some things going on in the labour market which could possibly make this less of a reliable indicator than it has been in the past. First, Hurricane Beryl could have affected this month’s print. Perhaps more importantly, unemployment has been edging up partly because so many new people are entering the labour force. Domestic participation is rising and immigration in the US in the last two years has been extraordinary.

However, we wouldn’t dismiss recession risk altogether. The US economy is slowing. It had to, after the heady post-pandemic consumer boom. Now with pandemic savings largely depleted, there are signs of stress, particularly in the lower income cohorts.

Markets had perhaps become complacent about recession risk. Indeed, pricing at certain points in the first half of the year looked consistent with ‘no landing’ rather than ‘soft landing’ and that was too good to be true. The fact that the equity market has seen a modest setback is not therefore surprising.

However, I’m not at this stage worried about things turning particularly ugly. Investors are often focused too narrowly on the question of whether there will be a recession or not. In fact the more important question is does the economy look set for a lengthy of prolonged recession. Markets will often look through a 5% or 10% contraction in earnings, provided a rebound is in sight ahead. It’s the 20%+ drawdowns you have to worry about.

I simply don’t see the foundations for a big contraction. Busts follow booms, usually those that have been driven by debt. But there hasn’t been a worrying boom. In fact, households and companies in the US have been paying down debt in recent years. The accumulation of leverage in the economy recently has been by the government but no big retrenchment is planned. If anything, the US election debate is about more fiscal stimulus rather than less.

So is the US headed for recession? I wouldn’t absolutely rule it out but if it does, I think it will be short and shallow.

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