Recession Fears Ratchet Higher Again This Week

Scott Anderson
Chief Economist
Bank of the West

No doubt the U.S. economy is slowing down and recession fears are at a fever pitch, given the sharp equity market selloff so far this year, but we are still a ways away from an outright and sustained contraction in real GDP and job creation in the United States. How do I know? Well one the best coincident indicators of economic contraction is the weekly initial jobless claims report. This timely measure of job loss in the labor market has seen only modest increases since claims hit a low 166k in March - the lowest level in claims since 1968. But at just 229k claims last week, this measure of labor market distress is still 45% below the level of claims the economy was experiencing last August. Indeed, jobless claims remain about in-line with pre-pandemic expansion levels. In short, no sign of a labor market recession yet.

Initial Claims Only Showing Tentative Signs of Softening

The other area of the economy that should give us an early read on whether the economy is about to go off the deep-end is the housing market. We have gotten a number of warnings from the NAHB Housing Market Index, which has been declining over the past six months, and housing starts and permits that plunged 14% and 7% respectively in May, that potential homebuyers are having some difficultly digesting higher mortgage rates. But the nearly 11% jump in new home sales in May and upward revision in past month sales remind us the housing market is coming from a position of strength and the deterioration in housing market conditions is unlikely to be a one-way street at least for a while.

New Home Sales Jumped 10.7% in May

Potential homebuyers are jumping back in, suddenly seeing a bit more inventory available and fearful that mortgage rates are just going to go higher from here. In short, the housing drag on economic activity and consumption is not yet a game changer for this economic expansion. Not ruling out the possibility that it will be by 2023, but for now it is just one of our many downside risks to the growth outlook.

I can envision many things that could put the U.S. in recession by next year, including further aggressive interest rate hikes from the Fed, another extensive equity and bond market selloff from current levels, a sharper than expected drop in U.S. home prices, and a business investment retrenchment as corporate profits struggle under rising input costs and softening demand. Indeed, I cut our U.S. economic growth forecasts for the second half of the year once again this week, incorporating the new information on the sharp drop in S&P Global's Manufacturing and Services PMIs for June and the expected drag on consumer spending, confidence, and business investment from the drop in equity prices and tightening financial conditions.

Looking at the latest reading of Robert Shiller's Cyclically Adjusted CAPE Ratio, the 18-26% decline in the S&P 500 and NASDAQ since the beginning of the year has barely put a dent in the stock market's overvaluation problem. The P/E ratio on June 24th was 30.00 just off of November's peak 38.58 and just below the peaks seen in the dot-com bubble and the 1929 stock market crash that helped trigger the Great Depression. Should equity valuations drop back toward historical norms, we could easy see another 25% or even bigger stock market decline from here.

Stock Valuations Still Look Too Rich Given The Outlook

Our current baseline forecast is for U.S. GDP growth to slow to around 1.0% annualized in the second half of 2022 from 1.8% in the second quarter. Real GDP growth for 2023 is expected to start around 0.8% annualized and slow to just 0.5% by the end of the year. Slowing real consumer spending and non-residential fixed investment growth are the primary catalysts of the slowdown. On a Q4/Q4 basis Real GDP growth is forecast at an anemic 0.6% in 2022 and 2023 down from 5.5% in 2021. This is about as close to a U.S. recession forecast as you can get without actually falling into one. The Fed's path to a "softish landing" for the U.S. economy continues to narrow, but is not yet completely blocked.

To learn more, check out this week's U.S. Outlook Report.

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