Growth in 2024. Nevertheless, a historically accurate yield curve indicator suggests that the risk of recession remains above average. (Illustration by GraphicaArtis/Getty Images)Getty Images
Consensus expectations for US economic growth have improved since market participants began to sense the end of the Federal Reserve's (Fed) short-term interest rate hikes in late October. After the last meeting in mid-December, Chairman Powell's comments made the Fed's shift from considering rate hikes to discussing the timing of the first rate cut more clear. After the transition, estimates for real GDP growth in 2024 continued to rise and are now at 1.3% year-on-year. This result would still be a reasonably below-average expectation, with growth of around 2% considered the expected long-term average.
But how much confidence should anyone have in the accuracy of this forecast? This year's example makes it clear that consensus forecasts can deviate far from reality. At the beginning of this year, the economy was expected to grow at a snail's pace, but growth has been better than expected and will almost certainly be above 2% in 2023.
Consensus forecasts for US GDP growth
Glenview Trust, Bloomberg
Meanwhile, the probability of a recession within the next 12 months has fallen from its recent peak but remains elevated at 52%, according to the New York Fed. Historically, when these high levels are reached, there has always been a recession. This recession indicator uses the yield curve to predict an economic downturn, one of the best predictors available. Despite its strong track record, the yield curve is not infallible and, even when represented correctly, has varying lead times. There is a legitimate debate about whether the combination of the impact of COVID and the accompanying ultra-low bond yields is making the yield curve less potent this time around.
Probability of a recession
Glenview Trust, Bloomberg
If the Fed does not change interest rates when inflation is falling, the constraint on the economy increases. The Fed's real interest rate, post-inflation, is expected to rise in early 2024 if the Fed keeps short-term interest rates at their current levels. Powell noted in his press conference after the Fed's meeting in December that the decline in inflation “may make it appropriate to reduce the level of policy restraint in place.”
The crucial problem is that interest rate increases occur with a variable delay. Recession could be avoided if the Fed manages to ease conditions before economic tensions become apparent. Futures markets currently expect the Fed to begin cutting short-term interest rates in March, making at least six cuts of 25 basis points (0.25%) each.
Fed funds rate after inflation
Glenview Trust, Bloomberg
Assuming July 26 was the last rise in this cycle, shares fell 9% in the three months following, but are expected to be up over 5% after five months. Typically, the end of the Fed's rate hike cycle has resulted in above-average equity returns, although not without some instances of notable losses.
S&P 500 returns after Fed's latest rate hike
Glenview Trust, Bloomberg
Interestingly, the two cases of negative stock returns in the year after the last rate hike were in 1987 and 2000. There was no recession after the 1987 rate hike cycle, but a recession followed ten months later in 2000. In this small sample since 1984, a recession followed shortly after the first rate cut in more than 40% of cases.
Publish the Fed's latest rate hike
Glenview Trust, Bloomberg
Stocks currently appear to have a high probability that the Fed can prevent a recession with its rapid change in monetary policy. First, the S&P 500 is near its all-time high in January 2022. Second, the more economically sensitive cyclical stocks significantly outperformed the less economically sensitive consumer staples stocks. This cyclical outperformance has been very pronounced since late October, when yields began to fall and markets began to sense an impending change in Fed policy.
Cyclical stock outperformance since the end of October
Glenview Trust, Bloomberg
Recessions have always hurt stock returns; the typical decline is over 24%. In stock declines that have occurred around recessions since 1929, the S&P 500 peaked or coincided with the start of a recession. It should also be noted that the S&P 500 fell around 20% nine times in the post-World War II period without experiencing a recession.
S&P 500 returns despite recessions
Glenview Trust, Bloomberg
The likelihood of a soft landing and avoidance of an economic recession should increase with this Fed reversal before any significant economic deterioration occurs. However, history provides no clear indication of how likely it is that the Fed will avoid a recession by cutting interest rates. Still, a historically accurate yield curve indicator suggests we should remain cautious. The bigger challenge is that this positive outcome is far from certain and a lot of good news is priced into stocks with robust gains in 2023. The market's better expectations are not a reason to get out of stocks, as they could be correct, but one should be prepared for possible turbulence as the Fed aims for a soft landing for the economy. This is an excellent time to monitor portfolio risk levels and assess the resilience of individual investments to a potential economic downturn.
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I am the Chief Investment Officer of Glenview Trust Company, which provides investment management and estate and financial planning to wealthy families. I appear often on US and international television and have been featured on ABC, Bloomberg, Bloomberg Asia, CNBC, CNBC Asia, Fox Business and NHK World. Previously, I served as Global Chief Investment Strategist for PNC Asset Management Group. With over $140 billion in assets under management at PNC, I served as the primary driver of asset allocation and model portfolio construction for high net worth individuals, family offices and institutional investors. I began my career on Wall Street as a financial analyst at Salomon Brothers, where I first came into contact with Warren Buffett. I have a bachelor's degree from the University of Dayton and an MBA from the University of Pittsburgh. I have also earned the Chartered Financial Analyst® (CFA®) and Chartered Market Technician (CMT) designations.
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