How changes in the pandemic era can keep the economy alive and turn the recession narrative on its head

Published: May 16, 2023 at 2:41 PM ET

It wasn’t the relatively small scale of the rebound in the April US Retail Sales report that caught the market’s attention on Tuesday, but rather the rebound itself. After data showed sales at US retailers fell just 0 .4% up, below 0.8% economists were expecting a percentage increase, traders joined in, focusing on the fact that sales didn’t fall the way they did in four of the five months leading up to April. Other data released on Tuesday showed that industrial production rose a better-than-expected 0.5% in April after two months of stagnation, and that builder confidence rose for a fifth consecutive month in May amid ongoing shortages…

It wasn’t the relatively small scale of the rebound in April’s U.S. retail sales report that caught the market’s attention on Tuesday, but rather the rebound itself.

After data showed that sales at US retailers rose just 0.4% last month, below the 0.8% increase economists were expecting, retailers joined in, focusing on the fact that the Sales didn’t decline as they did in four of the five months prior to April. Other data released on Tuesday showed that industrial production rose a better-than-expected 0.5% in April after two months of stagnation, and that homebuilder confidence rose for the fifth straight month in May as the US continued a shortage of building supplies houses for sale prevails.

Yields on 3-month to 30-year debt all rose on Tuesday, supported by the possibility that inflationary pressures may have more leeway. Traders raised the probability of another quarter point rate hike by the Federal Reserve to as high as 30% at times in June. And economists, analysts and traders wondered about a non-baseline scenario in which the economy doesn’t slide into recession as easily as many people think.

Read: Why a 5% interest rate might not derail the stock market or the US economy

“Even though interest rates are above 5%, we’re not seeing the same type of slump that we would normally see in the economy,” said Lawrence Gillum, Charlotte, North Carolina-based chief fixed income strategist at LPL Financial. “We have seen no increase in corporate default rates, and consumer defaults are below long-term averages. Businesses and households can continue to pay their bills.”

In addition, there is still a high demand for labor and the labor market remains stable, Gillum said over the phone. It all adds up to a 25 to 30 percent chance of a scenario where the economy just muddles through and some sectors like manufacturing are at risk of recession while others like services do well. However, LPL Financial sees a 60 to 65 percent chance of a recession in the second half of this year, he said.

Recession concerns returned to focus on Tuesday after Treasury Secretary Janet Yellen said a US default on its sovereign debt could trigger an economic downturn. On Monday, Raphael Bostic, President of the Federal Reserve Bank of Atlanta, told CNBC that he doesn’t expect any rate cuts until at least 2023, even if there is a recession — which hasn’t stopped fed-fund futures traders from pricing in rate cuts anyway .

Inflation was the biggest game changer to emerge from the Covid-19 pandemic. It ended an era of low interest rates and caused great turbulence on the financial markets last year. It continues to prove durable despite the CPI annual base rate falling below 5% for the first time in two years, and even after the Federal Reserve hiked rates since March 2022.

What is less debated is whether another powerful byproduct of the pandemic is an unexpectedly stronger US economy — an economy that is less sensitive to higher interest rates and less prone to downturns.

The pandemic may have created a “survival of the fittest” environment in which the “most resilient companies survive,” said Derek Tang, an economist at Washington-based Monetary Policy Analytics. As businesses and households “build up their defenses against extreme events,” inflation and consumption are not falling as much as might be expected.

An example of unexpected strength is seen in housing, where many homeowners locked into previously low interest rates are not selling their homes, limiting the supply of homes to new buyers and keeping prices high.

“You can spot a lot of recession indicators, but they are based on history of how the economy normally behaves. And it’s possible to have, say, a manufacturing recession but not a general recession,” Tang said over the phone.

While his firm’s baseline scenarios still call for a recession this year, Tang said a “muddling through” scenario could be good for stocks, assuming the strongest companies capture larger market shares. Such a scenario, however, would “create a lot of volatility in interest rate markets as the Fed pauses and embarks on a choppy trajectory that isn’t targeting longer rates, just higher rates.”

Gillum believes that in a robust economic scenario, stock markets can do well as long as inflation falls back to 2% fast enough to indicate that the Fed’s job is done. However, a “non-ideal outcome” from stagflation would see markets fare less well as yields would need to rise to reflect ongoing inflationary pressures and the possibility of further Fed rate hikes.

After Tuesday’s retail sales, government bond yields rose, led by the 1-year yield

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That rose 13 basis points to 4.9% in afternoon trade. Traders and investors overcame the debt ceiling problems by buying the one-month Treasury bill

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Meanwhile, US stocks

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were mostly lower.