fears have hit a fever pitch. From Wall Street’s sell-side research houses to regular American households, worries that the economy is about to go into a slump. According to Google Trends, “recession” for searches are spiking. In the US, the phrase “how to prepare for a recession” has almost tripled in search interest over the past week. These household recession concerns go hand in hand with inflation concerns, as well as surging prices around search interest.
But my sense is that recession and inflation around the fever is about to break. When sell-side analysts are competing to see who can make the most dire recession prediction and ordinary people are going through these topics, we’ve likely hit peak freak-out. And given the recent, sharp decline in the stock market, you can be sure investors have already priced in these recession concerns. This high level of worry is likely to have three things on the horizon: cooler inflation, a declining risk of recession, and the potential for the stock market to head higher.
Things look pretty good, actually
The latest economic data from WhatsApp is about the recession discussion. The doom-and-gloom chatter has picked up at a time when the US economy is expanding to a healthy clip, and recent economic data are beating economists’ estimates.
Take the jobs report: Nonfarm payrolls averaged a monthly growth of 552,000 in the first quarter, compared to 627,000 in the fourth quarter of 2021 and 515,000 in the third quarter of 2019 – before the pandemic. That’s a slowdown with hardly consistent, let alone a recession. Americans are also consistent with strong economic growth.
And what about manufacturing? The ISM Manufacturing PMI, a gauge of manufacturing purchasing managers’ outlook for their business and the economy, peaked 13 months ago. But a slowdown of the actual manufacturing of the measures. Manufacturing has advanced an annualized rate of 9.1% over the past three months. Averaging the three-month ending March, factory output grew at a 5.4% annual rate in the first quarter, compared to a 5.6% growth in the fourth quarter of 2019.
All of this data is consistent
Growth of about 4% to 5% – stronger than many years since the 2008 financial crisis. Not surprisingly, the Atlanta Fed’s GDPNow tracking estimate also shows that the Gross Domestic Product of Components is based on the underlying demand from American households and businesses at about that level. Overall GDP projections come down to net exports and inventory investment, the two most volatile components. But when those elements fluctuate, the private domestic demand pieces of GDP are more indicative when it comes to forecasting real GDP and employment growth in the quarter.
Moreover, both Europe and China have struggled so far in 2022 that the war on Ukraine and COVID-related shutdowns, respectively. I have a difficult time finding out how Europe and China can get worse in 2023 – and where there is a good chance both regions are strong next year. If growth outside the US picks up, it’s hard to see the US slipping into recession. The US can deal with weak growth overseas, but other regions find it hard to manage when the US is slowing down.
Bottom line: Recession risks are poised to drop meaningfully
Inflation has surged, and it’s no wonder that people are concerned. Over the past three months, the headline consumer price index has climbed 2.7%. That’s more than just three months in any single year going back to 2009. While I’m not ready to lay aside my concern about the inflation outlook, the situation is likely to get worse in the coming months. Inflation rates may remain elevated, but they likely won’t continue to go up to three key reasons.
First, a significant source of inflation pressure – used-car prices – is now fading. Prices for used cars and trucks are down 4% over the past two months, and the prices of the measures suggest recent wholesale auctions that continue to decline. Importantly, as supply-chain pressures ease, motor-vehicle production appears to have picked up: In March, motor-vehicle assemblies hit their highest levels since January 2021. There’s plenty of catching up, but we’re clearly heading in the right direction. This may be the reason why new cars have been moderated in recent months, too.
Second, the US dollar is getting stronger. When the dollar gets stronger, it becomes cheaper for Americans to buy products from abroad. One-fourth of US imports come from the euro area, the UK, and Japan. Since these currencies, the importers’ cash will go up and buy goods from these countries. This should also be the case, with a standard rule of thumb that every 10 percentage-point increase in broad dollar index shaves is 0.2 percentage points off core inflation one year later. The broad dollar is up about 7.5% over the past year, which implies a downward pressure on inflation.
Third, expect inflation to be unmoored. These expectations are important because they can be a self-fulfilling prophecy. If Americans expect prices to go up over the next few years, they will be more willing to take the stomach up and down the road, and so on. While short-run inflation expectations have surged on the back of rising food and energy prices, medium and long-term inflation expectations (which are much more predictive of inflation in the long run) are higher. As an example, in the New York Fed’s Survey of Consumer Expectations, the median one-year-ahead expected inflation rate is now at a new high, but the expectation is that the inflation over the next three years will be five months ago.
These factors don’t mean the US is going to get back to the Federal Reserve’s 2% inflation target anytime soon, but it’s clear the situation is getting worse.
Stocks for good news
So in the face of the seemingly unrelenting negativity, there are clearly some upsides: Stronger nominal economic growth and the likelihood that future price hikes won’t be as steep. And since the stock market has been largely over the past few weeks, there have been good fears that investors have fully digested these fears. As the outlook starts to improve, that should be a positive catalyst for equity markets. Moreover, the market has already had a lot of Fed interest-rate hikes over the course of the year, so any further increases in rates will not shock the market or send it into a downward spiral.
There are, of course, some risks. For one thing, labor markets may continue to tighten, putting upward pressure on wages. Eventually, this could put the Fed’s longer-run objective above a fair bit of price growth. It’s almost like getting a person in shape: “I’ve dropped 30 pounds over the past 12 months, but my cholesterol is still over 250!” Much like this theoretical dieter of the journey, The Fed’s journey is not yet complete. If these inflation pressures keep the overall rate higher than the Fed wants, even as prices for some goods come down, this could force the Fed to get even more aggressive down the road – which would be a surprise for investors and possibly drive-in stocks.
But for now, it seems like things are getting better – what you may have heard. Inflation is not surging away from the Fed. Underlying demand is accelerating. Put differently, the composition of the US’s nominal economic growth is: instead of rising from just rising prices, we are also seeing a bit more growth moving from a larger quantity of goods. That’s welcome news for the stock market and for the anxious of everyday Americans.
Neil Dutta is Head of Economics at Renaissance Macro Research.