Viewpoint

August 09, 2024 | 15:15

August 9, 2024

Economist

Chief U.S. Economist and Managing Director
Economics

Scott Anderson is BMO’s Chief U.S. Economist and Managing Director. He analyzes and forecasts U.S. national and ... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with BMO Capital Markets since 2006. He plays a key role... (Read more)

Priscilla Thiagamoorthy

Senior Economist and Vice President
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Scott Anderson , Ph.D.

Chief U.S. Economist and Managing Director
Economics

Scott Anderson is BMO’s Chief U.S. Economist and Managing Director. He analyzes and forecasts U.S. national and ... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with BMO Capital Markets since 2006. He plays a key role... (Read more)

Priscilla Thiagamoorthy

Senior Economist and Vice President
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Our Thoughts

Eyes Wide Shut

The equity market woke up to the risks on the employment side of the Fed’s dual mandate, really for the first time since the recession calls of 2022. The Fed nodded to the changing risks with a pivot in the July FOMC statement: “the committee is attentive to both sides of its dual mandate” and retiring the language that policymakers are “highly attentive” to inflation risks, giving equal weight to both sides. Comments by Jerome Powell at the press conference that “if we see something that looks like a significant downturn in the labor market, we would respond” reinforced that message. Even so, a disappointing July jobs report proved a tempting reason for investors to condemn the Fed as being behind the curve, cash in their high-flying winners, and take some risk off the table.

At its low this week, the S&P 500 lost about 9% from the July 16 peak, while the Nasdaq breached the 10% correction threshold. Stocks managed to recover a small fraction of their losses over the last few trading days, but equity markets are clearly still on edge. The market volatility has been exhausting. Now might be a good time to take a breath—and an inventory—of what, if anything, may have changed.

Doug and Rob take a deeper dive into recession risks below. Thankfully, there are still not a lot of obvious red flags of recession in the U.S. today. Nonfarm payrolls are still growing, layoffs and initial jobless claims remain low, retail sales are likely still growing, and second quarter earnings reports have been solid. The ISM Services Index improved in July and stronger than expected (Chart 1), and initial jobless claims sank by 17K to 233k, its lowest reading in a month. The Atlanta Fed’s GDPNow estimate for Q3 remained at 2.91% on August 8, little changed from recent readings, while NY Fed’s Nowcast was at a solid 2.24% on Friday. Both estimates are still well above our forecast of 1.3% and the Bloomberg consensus forecast at 1.5%.

It’s mostly the sharp rise in the jobless rate that has everyone spooked. At 4.3% in July, it’s already slightly above the FOMC’s median 4.2% long-run rate and well above the Q4 median projection of 4.0% made in June. The 0.6 percentage point increase in the unemployment rate since January and 0.9 percentage point increase since the January 2023 low has taken center stage of the narrative, especially with the triggering of the Sahm Rule recession indicator in July (Chart 2). But Dr. Sahm herself has said her recession indicator maybe throwing off false signs this time around, pointing to the rise of immigration that could be temporarily pushing up the labor force and unemployment rate. In other words, an increase in labor supply rather than a decrease in labor demand that could be a harbinger of impending recession. The relatively tame initial jobless claims data to-date seems to back that argument up (Chart 3). Still, the unemployment rate has already risen more than expected, and we have marked up our forecast for the peak to 4.8% from 4.3% previously, expecting a somewhat more prolonged slowdown in consumer spending into the first half of 2025, but not necessarily a deeper decline in GDP growth. We remain in the below-potential growth, soft-landing camp and see a path to escape recession if the Fed eases steadily, at least a quarter percentage point, at each of its next five FOMC meetings. A more balanced labor market no longer requires a highly restrictive monetary policy.

The labor market is just one end of the Fed’s dual mandate. Next week, we will get a fresh view of the inflation side with the release of July’s CPI and PPI reports, and some hard data on July retail sales. They might offer a counterweight to the increasing bets of a 50-bp cut at the September meeting. We expect to see a small rebound in CPI inflation (both headline and core) that will remind everyone that annual growth could remain sticky for much of this year due to unfavourable base effects. Retail sales are also forecast to keep growing a bit above the pace of inflation, signaling that not all consumers are retrenching and that modest-to-moderate real consumer spending growth continues.

Consumer Stress is Building

Consumer stress is mounting due to a combination of high interest rates, elevated prices and a cooling labor market. Consumer prices are up 21% since the pandemic began, and consumer inflation surged to 9.1% in 2022, its highest level in more than 40 years. Consumers were initially able to manage the surge in prices by relying on excess savings accumulated during the pandemic, but the Federal Reserve Bank of San Francisco estimates that excess savings were depleted by March 2024. At the same time, credit card balances began to increase and hit a new record high of $0.99 trillion in the fourth quarter of 2022. Credit card balances have mostly moved higher since then and hit a fresh record-high of $1.14 trillion in the second quarter of 2024, according to the New York Federal Reserve (Chart 1).

While the first year-ago increase in credit card debt since early 2020 was a modest 4.5% in the fourth quarter of 2021, growth then began to accelerate sharply amid the initial increase in interest rates in March 2022 and high inflation, suggesting households were increasingly tapping credit cards to support their spending. Thereafter, credit card debt rose at double-digit rates year-on-year for nine successive quarters with growth currently sitting at 10.8% (Chart 2). While this is down from 17.2% in the first quarter of 2023, the sustained accumulation in card balances has provoked concerns about the ability of households to service the debt.

While not minimizing the seriousness of the record-high level of credit card debt, it is important to put it into perspective. Total credit card debt as a share of disposable income was 5.5% in the second quarter of 2024 (Chart 3), spot on with the pre-pandemic ratio and below the long-run average of 6.1% from 2003-2023. What is more concerning is the trend. The ratio was just 4.0% in the first quarter of 2021 and has climbed steadily despite the favorable environment of solid economic growth and, until recently, a tight labor market.

The credit card delinquency rate, however, is more worrisome. The percent of card balances 30 or more days late increased to 2.3% (non-annualized) in the second quarter of 2024 (Chart 4) and has climbed sequentially since hitting an all-time low of 1.0% in the fourth quarter of 2021. Furthermore, the rate is above the long-run (2003-2023) average of 2.0% and is at the highest since the first quarter of 2011.

The credit card delinquency rate will likely continue to climb gradually in tandem with a rising unemployment rate. The jobless rate is currently at a still historically low 4.3%, but that is up from 3.4% in April 2023. Our forecast is for the unemployment rate to rise to around 4.8% in the first quarter of next year and remain above 4.5% through the end of 2025. Although the credit card delinquency rate is expected to rise, it will likely not approach the record high of 3.4% during the Global Financial Crisis of 2008.

Recession Risk Redux?

The recent financial market maelstrom was caused by a variety of factors—geopolitical tensions, the unwinding of the yen carry trade, some election uncertainty, and recent jitters on tech earnings/valuations, all landing among normally thin August markets. But, at its heart, the volatility was sparked by renewed concerns over the economic outlook, and specifically whether recession risks had reemerged after markets had earlier been lulled into believing a soft landing had been achieved. One of the proximate triggers for the market slide was the sudden two-tick rise in the jobless rate to 4.3% in July, just days after Fed Chair Powell hinted at some growing concern over the health of the job market. While markets have calmed after the three-day 7% drop in the All-World MSCI, the lingering questions over the near-term economic outlook have not entirely dissipated. How real are recession risks?

First, let’s consider the recent market squall in a broader context. While the S&P 500 has not yet even reached full correction territory (a 10% drop), the spike in the closing VIX to above 38 on Monday is a rarity—not to mention the mid-day spike to above 60. Even on the closing level, such a high level has happened only on 15 other occasions in the past 30 years, or about once every two years (Chart 1). Certainly there have been plenty of false alarms from market squalls—the granddaddy of false alarms was the 1987 market crash—but intensified market volatility has also typically served as a warning bell for the onset of recession in many other cycles. The trick is to separate the noise from the signal.

Going back to that infamous 1987 episode, we consider 10 unique market dislocations that saw the VIX jump to 35 or higher on a closing basis (Table 1). The first thing that becomes clear is that the range of market triggers is wide-ranging, including technical crashes (1987, 2010), external economic developments (1998, 2015), a pandemic (2020) and more textbook recessions (1990, 2008). In all cases, equities have fallen more than 10% (a technical correction) and, in some cases, into a deep bear market (most notably during the Global Financial Crisis). Treasury yields have typically fallen, while the Fed has more often than not responded. A U.S. recession followed on the heels of 4 out of these 10 major market dislocations. The broad takeaway is that recessions have almost always been led by a major market dislocation; but a major market dislocation doesn’t necessarily imply an imminent recession. One must be attentive to the phase of the cycle in which these episodes occur. The fact this instance is occurring after an aggressive tightening cycle, and alongside an inverted yield curve, suggests that we should at least take it seriously.

Now let’s consider the current recession risks. Plenty of ink has been spilled on the U.S. job market breaching the Sahm Rule, with the three-month average unemployment rate rising by 0.5 ppts from the low of the prior 12 months. Even a quick perusal of the yearly change reveals that almost any non-trivial increase in the jobless rate has been associated with broader economic downturns (Chart 2). Yet, even Sahm herself has somewhat disavowed the rule in this case, as there are so many unusual aspects to this cycle—including the low starting point for the jobless rate, the gradual nature of the rise, and relatively strong population growth in the past year. And while payroll growth stumbled somewhat in July (at 114,000), it has still averaged close to 200,000 in recent months and its 1.6% y/y growth rate would seemingly indicate a solid base for ongoing expansion. However, the household survey has reported virtually no job growth over the past year (0.04%) which, like the unemployment rate, is a clear-cut sign of recession risk.

Curiously, few other major economic indicators are sending off warning signs, with real GDP up a solid 3.1% y/y (and 2.8% a.r. in Q2), retail sales and auto sales steady, and industrial production solid in recent months, to name a few. True, economic surprise indexes have been consistently in the red of late, and ISM surveys are just above concerning levels. But, on balance, there are no significant signs of stress yet, pointing to an abrupt shift in the economy. Some recent corporate earnings reports have indicated increased consumer caution, but the latest confidence surveys are right in line with long-term norms (Chart 3). Notably, some lower income groups, just below median levels, are becoming less confident amid a softening job market, which may be driving some of the negative commentary from companies.

While coincident indicators may not be pointing to trouble, forward-looking indicators are somewhat less sanguine. There is still the small matter that the inverted yield curve has been a fool-proof recession leading indicator for 50 years, or 8 cycles (Chart 4). And even though it’s been more than 18 months since the curve first inverted, we are not completely out of the woods on that front, as at least one cycle didn’t see the recession begin until 20 months after the first inversion. Similar to the Sahm Rule on unemployment, it is possible that “this time is different”, owing to the unique nature of the current cycle. But it would be unwise to also dismiss the curve out of hand.

Taking these strands together, we believe that the U.S. economy will manage to stay out of a full-blown recession, assuming there are no major external shocks. We look for growth to ebb, with GDP likely averaging just under 1.5% over the next four quarters, or half the pace of the past year. However, it is fair to conclude that recession risks have increased recently. After consistently shaving recession probabilities since early 2023, the consensus forecaster pegged the odds of a downturn over the next 12 months at 28% in the latest quarterly survey in July—just prior to President Biden stepping aside and the recent market volatility (Chart 5). Following events of the past week, some have upped those odds to around 35%; we have no quarrel with that estimate.