The risk of recession is not zero

like we have discussed recently, Wall Street economists increasingly believe that the risk of recession has receded significantly. To understand:

“economists don’t think the economy is headed for a recession. In January, they, on average, predicted growth below 1% in each of the first three quarters of this year. Now, they expect growth to bottom out this year at an inflation-adjusted 1.4% in the third quarter.” – WSJ

Of course, this perspective seems contradictory to many indicators with a long history of earlier recessionary starts, such as yield curve inversions. As shown, we currently have the longest and most consistent period in history where the yield spread between the 10-year Treasury bond and the 3-month Treasury bond has inverted. However, no recession has appeared this time.

Another historically reliable indicator of recession is the 6-month rate of change of the Leading Economic Index. As with yield curve inversions, the current depth and duration of negative LEI readings have always coincided with a recession. But again, the US has avoided such an outcome.

Of course, the Federal Reserve’s tightening of monetary policy through one of its most aggressive rate hike campaigns also failed to push the economy into a recession.

As the economy has continued to defy recessionary expectations, it is understandable that economists have “delivered” anticipating one.

But has the risk of recession disappeared?

The risk of recession is not zero

A very funny meme is circulating on social networks. Yes, cute and cuddly animals look safe, but “The risk of them killing you is low, but never zero.”

This seems like an appropriate meme, given that the risk of recession in the economy may be low right now, but it’s not zero.

like discussed earlierone of the main reasons why the economy has defied the drag of recession from higher borrowing costs has been the ample supply of fiscal support through previously passed spending bills such as Inflation Reduction Law AND Chips Act. When combined with stimulus checks, tax credits and moratoriums on payments on debt as diverse as rent and student loans, the amount of monetary support for consumption supported economic growth as the Federal Reserve tightened monetary policy.

What is essential to understand is that the increase in monetary support acted as a “adrenaline” stimulus for the economy. Yes, many economic data series suggest that the risk of recession has increased. However, the increase in monetary injections drove the economy into overdrive, as evidenced by economic growth in 2021.

The crucial point to understand, and one that eludes most economists, is that the economy slows down like this “adrenaline” boost fades. If the economy had grown at a nominal 5%, as in 2019, the fall from the post-pandemic peak would already register a recession. However, as nominal growth approached 18%, it will take much longer than normal for growth to return below zero. To show this, we looked at the number of quarters between the peak of economic activity and the entry into recession. Using this historical analysis, we can estimate that the return to economic growth in a recession can take approximately 22 quarters. Such would be the timing of the next recession in late 2025 to mid-2026.

Many things can certainly happen to extend or shorten that estimated time frame. However, the point is that a reversal of growth from high economic growth rates can last much longer than normal. Another similar period was the 25 quarters of slowing economic growth before the 1991 recession.

For investors, while consensus estimates of economists place the risk of a recession very low, it is not zero.

Economic data to watch

Given the long lag between recession indicators and economic recession, it is not surprising that economists gave up predicting a recession. However, while the recession hasn’t happened yet, that doesn’t mean it still can’t. We should pay special attention to data that are historically related to economic growth.

For example, real retail sales have weakened materially since the peak of economic activity in 2021. As shown, retail sales account for approximately 40% of Personal Consumption Expenditures (PCE). Therefore, it is not surprising that retail sales precede changes in PCE. The significance of this lead is that PCE accounts for nearly 70% of the GDP calculation. Therefore, as consumer demand slows, the economy slows and inflation falls. Real retail sales are now negative as consumers do not have excess savings, further slowing economic growth in the coming quarters.

Of course, without employment it is difficult to further increase economic consumption. Notably, while we count part-time employment, those jobs do not provide the wages and benefits of full-time employment to support a family. Surprisingly, a key leading indicator for every previous recession has been a change in full-time employment.

While it is certainly possible for the economy to avoid a recession, given additional monetary or fiscal support, government and business investment make a much smaller contribution to GDP than consumer spending. As noted in “Bad news is good news” with consumers strung between falling wage growth and higher living costs, the ability to leverage the debt gap is becoming increasingly challenging.

“The consequence of that lack of income growth is that they are the first to face the limits of taking on additional debt.”

Pay attention to future economic data. While it may take much longer than many expect, we suspect the risk of a recession is likely to be greater than zero.

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Lance Roberts is a Portfolio Strategist/Economist for RIA advisors. He is also the host of “The Lance Roberts Podcast” and editor-in-chief of “Real investment advice” website and author of “Real daily investments” blog and “Real investment report”. Follow Lance at Facebook, I tweet, LinkedIn AND to YouTube.