Investment Strategy Brief:
U.S. Economy Not Yet in the Clear

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

Over the past few weeks, investors and economists alike have become more optimistic on the potential for a soft landing that avoids economic recession in the U.S. Many have been focused on June’s benign inflation report and continued strength in the labor market. However, such wishful thinking before recessions is really nothing new. For example, the number of Bloomberg articles that mention the keyword “soft landing” has remained elevated since mid-2022, as it typically does before recession becomes a reality.

What’s been taking so long for the recession to show up? Part of the reason has been the massive savings built up during the pandemic. Federal and state governments issued unprecedented peacetime levels of stimulus in the form of various transfer payments like stimulus checks, enhanced unemployment benefits and various other programs that put cash in the pockets of Americans. Many chose to save those funds, which led to piles of excess savings above and beyond what households likely would have saved given pre-pandemic trends. That peaked around mid-2021 and has been supporting healthy consumer spending ever since. However, there are signs that its simulative impact may be fading, especially for U.S. earners in the bottom quartile, which tend to be more likely to spend any incremental dollars earned. They are projected to exhaust their extra savings this quarter in aggregate, which could be a headwind to economic growth into the back half of the year.

Part of what’s driving the soft landing optimism is a singular focus on coincident indicators rather than leading indicators. For example, many have cited the ongoing strength of the labor market as a sign that recession may be avoided, but employment tends to be more coincident in nature, meaning that it often gives a read on where the economy currently stands, not where it’s going. In contrast, leading indicators can help investors see beyond the present to where the economy may be headed. The Conference Board maintains indices of coincident and leading indicators, and it’s not surprising that before recessions, the leading indicators start to deteriorate. Once the recession actually occurs is when the coincident indicators start to fall. As it stands now, the difference between these indices is the largest observed in their history, which is entirely consistent with the historical instances of recession in the U.S.

So if we haven’t gotten that recession yet, when should we expect it? Judging how far in advance these leading indicators are likely to lead is not always a hard science. Economic variables notoriously act with long and variable lags. Take, for example, the fed funds rate. Whenever it passes through estimates of neutral, which is the rate that is neither stimulative nor restrictive for the economy, the clock starts to tick on recession starting up in the near-term. During the last three economic cycles, the range of time between crossing neutral and the start of recession has been between 9 and 22 months. The Fed passed through neutral last fall, so applying that range to this cycle could mean a recession start date sometime within the next few months or next year.

But that’s just one of many reliable variables that can give us an idea of when to expect this recession. Several high-profile leading indicators, such as Glenmede’s proprietary Leading Economic Indicator, the yield curve and the fed funds rate discussed earlier can help give further clues. Applying a similar methodology to these measures, a consensus of late 2023 to early 2024 as the start date of the looming recession starts to become more apparent.

Now the key point here for investors, is that the risk of recession remains high. However, equity markets do not seem to pricing commensurate with that risk. Glenmede currently estimates that valuations on U.S. large-cap equities sit at the 77th percentile, which implies they are 27% more expensive than fair value. Since 1970, there has never been a case in which large-cap equities have maintained premium valuations up to and through an economic recession. In fact, on average they have troughed at 25% discounts to fair value in recessions, suggesting there is significant downside to risk assets that may be failing to properly reflect the looming risk of recessions.

So to summarize, the soft landing hype has intensified recently as hopes that the U.S. avoids recession grow ever-higher. We haven’t seen recession yet, in part, due to a resilient consumer propped up by COVID-era stimulus. A key point underpinning the soft landing argument is an excessive focus on coincident indicators like employment, but many leading indicators continue to point to recession as the base case, beginning perhaps later this year or early next. Equity markets do not appear to be properly reflecting the likelihood of this outcome with still-premium valuations. For investors, this warrants a defensive portfolio posture given outsized risks in expensive equities.

Thanks for listening! And please don’t hesitate to reach out with any questions.

This material is intended to review matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. When provided to a client, advice is based on the client’s unique circumstances and may differ substantially from any general recommendations, suggestions or other considerations included in this material. Any opinions, recommendations, expectations or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Outcomes (including performance) may differ materially from any expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss any matter discussed herein with their Glenmede representative.