U.S. recession ifs and whens

Putnam Fixed Income Team, 06/16/22


The United States will likely avoid a recession in 2022, in our view. Still, the Federal Reserve’s increasingly hawkish tone on monetary policy, slowing economic activity and China’s continued deceleration are raising recession risks in 2023.

Fluid economic landscape

Overall, current economic dynamics in the United States are not consistent with a recession. We note that household consumption growth — especially for goods — has been trending lower. That said, the normalization of life post-Covid-19, which involved a shift from goods to services, looks like the stage of the economic cycle one would normally experience prior to recessions. Still, these indicators don’t necessarily signal a pending recession.

High business expectations play a role in recessions. Firms’ high growth expectations that are not met contribute to recessions. For now, there is no visible change in companies’ behavior at the macro level although business expectations have come off their highs. Job openings remain high, and businesses are adding to capacity. New orders growth indicated in business surveys has declined for months. Still, firms have added to inventories as supply worries dominate and business expectations remain relatively high.

Non-residential structures investment has remained stagnant for decades, while investments in equipment and information technology have surged. Residential construction has been resilient, while shortages of materials have slowed construction. The average time to construct a single-family house almost doubled over the past two years. Of these investment components, equipment investment looks like the most vulnerable to a surprise, but it is not likely on the verge of an immediate collapse.

Residential investment remains resilient, and business spending on information technology has surged

(% of U.S. GDP)

Source: U.S. Bureau of Economic Analysis, as of March 31, 2022.

Past performance is not indicative of future results.

Supply bottlenecks have messed up the inventory dynamics during this cycle. Companies aren’t responding to orders and inventory levels in the usual manner. Since supply shortages are likely to stay — largely due to China’s zero-tolerance Covid-19 policy and the virus — precautionary stock building can continue. The tendency to maintain higher than usual stocks may result in excessive inventory building. A further drop in demand can quickly change this dynamic.

China’s pandemic lockdown policies have affected the global economy. This is largely because of the integration of developed countries and emerging markets into the global supply chains involving China. The lingering supply chain disruptions and slower domestic growth can be attributed to the government’s approach to virus outbreaks. We believe growth in China 2022 will fall short of the government’s goal of around 5.5%.

Ebbs and flows in business sentiment

We will likely see more visible signs of a recession when businesses downgrade their expectations. That will feed directly into their decisions, including hiring and investments. On that front, small firms tend to lead sentiment. Since costs for these companies are more domestically oriented, they experience margin squeezes earlier than larger companies that benefit from low labor costs elsewhere. Bigger firms that export to and have operations in other countries fare better during a U.S. slowdown, in our opinion. Large businesses have also tended to benefit more from excess global liquidity, while small firms have limited access to capital markets.

U.S. small-business confidence — as measured by the National Federation of Independent Business’s Small Business Optimism Index — has dipped since last summer. Current index readings hover near the lows of 2020, and expectations over the next six months are at the lowest level in the survey’s 48-year history.

Small businesses hiring and expansion plans have also slowed. Hiring by very small companies (1–19 employees) and small companies (20–49 employees), which make up about 27% of total U.S. employment, turned negative over the past two to three months. Job gains this year have been driven by medium- and large-sized employers only. Although these indicators are not pointing to a recession yet, we should note job losses in the leading sectors.

On the other end, while U.S. manufacturing and business activities, as measured by the Institute for Supply Management’s gauge of factory activity and the S&P Global Flash U.S. Composite PMI, have eased, the readings are comparatively better.

Risks of a recession are rising

We believe the U.S. economy will chug along this year despite declines in household spending and job growth. So far, households have relied on their savings and are loading up on credit card debt to maintain their living standards. We believe these spending patterns will continue during the summer months before consumers start to tighten their belts. Slower spending is likely to accelerate a downturn.

Slowing demand and elevated business expectations have set the stage for a noticeable decline in overall activity. What makes things worse is that the Federal Reserve has been tightening monetary policy aggressively. Given the U.S. economy’s current momentum, we believe the U.S. will avoid a recession in 2022. However, the risk of recession rises for 2023 because economic activity will likely continue to slow, China’s growth is unlikely to recover much, and the Fed is likely to remain hawkish as inflation surges.

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