There were many surprises for the US economy in 2022.
Perhaps most surprising is the fact that it has been so resilient in the face of 9% inflation while the Fed has undergone one of the most aggressive rate-hiking cycles in history.
Many people took it for granted that we are either (a) in a recession as early as 2022 or (b) doomed to be in a recession shortly.
A strong labor market combined with consumers who are keen to spend helped the economy to beat expectations.
The question is: what’s next?
Households can only spend their savings for so long. Ultimately, higher interest rates will affect economic activity. Businesses will be forced to make some difficult decisions.
Something has to give way…right?
In my view, there are three realistic scenarios for the US economy from here:
Scenario #1: Hard landing. History shows that in the past high inflation could only be solved by a recession.
Sometimes the Fed enforces it, while sometimes the economy just overheats, but we’ve never had a period of high inflation that didn’t eventually turn into a recession.
Most investment professionals, economists, and pundits assume this is the base case.
If you believe what the Fed is saying, a hard landing should be the base case because they keep telling us they have no choice but to cause an economic contraction to push inflation down to their target rate.
Scenario #2: Soft landing. This is the dream scenario, where the Fed is forced to retreat as the economy threads the needle if inflation falls without a significant slowdown in the economy or a significant rise in the unemployment rate.
There is no historical precedent for this, but there is no historical precedent for a pandemic combined with a gargantuan amount of fiscal stimulus, a supply chain shock and a labor shortage like we’ve never seen before.
A soft landing would look something like this:
- Inflation continues to come in at an annualized rate of 3-4% (same as the last 3 months).
- The number of job offers is falling, but the unemployment figures are not rising as much.
- Wage growth is slowing, but not below the rate of inflation.
- Economic growth continues through a combination of consumer spending, lower business input costs and a labor market that remains stronger than inflation.
I’m not sure how anyone really believes a soft landing is possible right now.
It seems unlikely, but we are living through an economic experiment where history may not be the best guide.
Stranger things have happened.
Scenario #3: No landing. This is your pilot speaking. Uhhhhh luckily…there’s bad weather where we’re supposed to land, so we’ll be continuing to circle the airport for the foreseeable future. We hope to get out of this queue as soon as possible.
The no landing scenario would be frustrating for impatient people who just want a solution one way or the other.
My definition of a queue would be more the same given the current environment.
That would be inflation coming in but staying above target, the jobs market staying strong, the Fed continuing to tighten, and the economy continuing to muddle through…until some kind of external shock (good or bad) pulls us out of this environment.
There are different probabilities for each of these scenarios, but none of them would surprise me in 2023 and beyond.
Oddly enough, even though you gave me the exact economic scenario for the coming years, I’m not sure I can tell you how the financial markets will react.
It would make sense for the stock market to roll over with a hard landing as earnings would likely fall in a recession.
But one could also argue that stocks would bottom well before a recession hits, assuming that’s already priced in.
It would make sense if the stock market resumed its uptrend with a soft landing.
But that probably depends somewhat on where bond yields and the fed funds rate go in this scenario.
Bonds could become a portfolio stabilizer again on a hard landing, but it likely depends on how inflation continues and how far the Fed goes with monetary policy.
I also have no idea what would happen to bond yields in a soft landing scenario. They might fall, but what if they just stay where they are for a while?
Sometimes the economy is based on the stock market. Sometimes it’s the other way around. Sometimes they contradict each other.
I’ve reached the point in my investing career where I’ve given up trying to predict the timing of the next recession, understanding that I know there will be one at some point, no matter what I think will happen.
You can’t control the economy, but you can control your reactions to the inevitable ups and downs it will bring us.
Michael and I talked about some potential trajectories for the stock market and economy in 2023 and more in this week’s Animal Spirits video:
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Further reading:
Are we headed for a recession?
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