Economic concerns are warranted, but we see five positive factors that differentiate our current conditions when compared to past downturns.
A majority of economists believe the U.S. will fall into recession in 20231, and it’s not difficult to see why. The Federal Reserve has taken its most aggressive actions in years to fight inflation, last year’s declines in both stocks and bonds have reduced consumer net worth, and the country’s largest banks and tech companies have begun to lay off workers. After 2022’s dismal market performance, investors are justifiably concerned about 2023.
However, we see five reasons why investors should not overreact to a potential recession.
1 Inflation is slowing.
While inflation remains well above the Federal Reserve’s 2% target, the rate of price increases appears to be slowing. The falling ten-year rate and other forward-looking measures of inflation expectations confirm this. If the trend continues, the central bank will have plenty of room to ease monetary policy in the event of a recession. This was not an option for most of the last fifteen years with short-term interest rates held at or near zero.
2 Most banks are well-capitalized.
The failures of Silicon Valley Bank and similar institutions brought back memories of 2008-2009, when several of the country’s largest investment banks and lenders failed. However, relatively few institutions took on the excessive interest rate risk that brought down Silicon Valley. Most banks are well-prepared to handle a downturn, unlike the severe downturns of 2008 and the 1930s and the savings and loan crisis of the late 1980s when capital levels were insufficient to protect against large loan losses. Over the last decade, lawmakers and regulators instituted higher capital requirements and annual stress tests that should ensure banks are able to lend and provide liquidity through a recession.
3 Labor is in short supply.
So far, the national level of unemployment is not a major concern. Fears of a 1970s-style “stagflation” with high inflation and high unemployment have subsided in recent months as the labor market is still under-supplied relative to the number of jobs available. The unemployment rate is 3.4%2, and businesses are generally reluctant to cut staff given recent struggles to hire and retain employees. These labor market dynamics also bode well for an eventual recovery.
4 Geopolitical rivals are struggling.
America’s largest international rivals, Russia and China, are dealing with problems of their own. Russia’s ill-advised “special operation” in Ukraine has turned into an extended conflict, and western Europe’s dependence on Russian gas was not as problematic as initially feared. In China, Xi Jinping consolidated power late in 2022 but was immediately forced to make an abrupt about-face on COVID policy as strict lockdowns threatened the Chinese economy and led to protests.
5 Valuations have already adjusted.
Valuations were reset at more reasonable levels after last year’s declines. At the beginning of 2022, 10-year government bonds were yielding only about 1.5% while inflation was running at 7%. Today, the same bonds yield 3.5% even as inflation expectations continue to fall. And while we expect earnings to fall along with the economy, stocks are now valued in line with their 30-year average relative to their earnings over a full economic cycle.3
Therefore, while we expect volatility reflecting a shifting balance between slowing economic growth and declining inflation over the next several months, we believe both stocks and bonds are unlikely to repeat their disappointing 2022 performance this year. The downturns of 2008 and 2020 were triggered by sudden collapses of the global economy triggered by massively leveraged financial institutions and a pandemic. In contrast, we expect more of a “typical” turn in the cycle this year.