[Contribution] Detailed examination of US recession risks

Risk factors of US recession controllable

Stephen Lee, chief economist of Meritz Securities

By Stephen Lee

We published our second-half economic outlook last month. For the U.S. economy, we anticipate that amid solid service-sector growth, the manufacturing sector will start to rebound by the fourth quarter of this year, as the Fed's rate hike pause will lead to declining real market yields, and hence, act as a tailwind for investment goods orders with a time lag. Korean exports will start to recover and will harmonize with the U.S.' manufacturing rebound by then.

Nevertheless, some say that such a view is too optimistic. Some believe the U.S. economy will eventually go into a recession with Federal Funds experiencing a rate hike of approximately 500 basis points within 14 months, and with an inverted yield curve. Others believe that U.S. inflation will be persistent and the Federal Reserve will choose only to implement more hikes, thereby resulting in the economy suffering more. The banking crisis and commercial real estate problem are designated as new risks, which surfaced in the first half.

Here I would like to express my views on why I still stand in the non-recession camp by covering the abovementioned risk factors.

Recession woes

It is perfectly natural to worry about an upcoming recession, with 2-year and 10-year treasury yields inverted (more than 100 basis points), with leading indicators trending downward. These issues are known and can often be seen as early warning signs before an actual recession takes place.

That said, we must consider the definition of a U.S. recession by the National Bureau of Economic Research (NBER). NBER looks at a wide range of indicators. Historically, when at least six out of eight indicators ― real GDP, real GDI, real personal disposable income, real personal consumption, real manufacturing and trade sales, industrial production, nonfarm payroll, and household survey employment ― contract quarter-on-quarter, NBER declares that expansion has stopped and recession has begun.

This compares to the conventional wisdom that states that two consecutive quarters of negative real GDP growth indicates a recession. We saw this in the first half of last year but no one pointed out that the economy was in a recession.

What about now? For the first quarter this year, all indicators stayed in positive territory except for industrial production. Real manufacturing sales and real GDP can contract in the next quarters due to the investment down-cycle, but that is only three out of eight.

For NBER to declare that a recession has taken place, income, consumption or employment numbers should contract. Income and consumption are unlikely to decline, as nominal income growth outpaces that of inflation and the existence of excess savings continues to serve as a buffer for consumption. Recession by definition requires job numbers to fall.

However, that is unlikely as well. Although labor costs surged in recent years, companies have passed on these cost burdens by raising their sales price. That is why we are experiencing inflation. According to the Bureau of Economic Analysis' (BEA) corporate account, under the National Account, nonfinancial companies' net profit margin stood at 13.7 percent as of the first quarter this year, well above the post-war average of 9 percent. This implies that there are hardly any wide-ranging layoff pressures driven by cost burdens.

Persistent inflation and Fed's overkill concerns

Some argue that inflation numbers will rise again as soon as the base effect from the first half of last year disappears. Others say that today's inflation is a trip back to the great inflation era of the 1970s and 1980s, which will lead to overkilling the economy by the Fed. I disagree, with respect to both arguments.

First, let us look at the CPI growth, which is measured by the recent 3-month percentage change during the prior 3 months (and annualized). It shows non-housing core services standing at 3.8 percent, core goods excluding used cars at 1.3 percent and housing at 6.5 percent (down from 9.2 percent in February).

All of this indicates that additional inflation pressures are contained, with the help of wage growth slowing. Year-on-year inflation numbers are likely to fall in the second half of this year.

Second, the great inflation of previous eras originated due to expansionary fiscal policy in a tight labor market. This is similar to today's episode. That said the duration of inflation lasted longer as the Fed hesitated to respond with aggressive monetary policies in the mid-1970s.

A non-monetary approach or administrative price controls were the norms back then, which is different from today's response. The Fed was behind the curve when addressing inflation last spring, but eventually caught up by implementing the fastest rate hikes in 40 years.

Although June's FOMC dot-plots suggest that, two more hikes are appropriate. This in itself indicates that the Fed can still control inflation. A decision will be dependent on data. With a wide-ranging disinflation process already underway and the Federal Funds Rate to exceed core CPI growth starting in June, the Fed is likely to stay put until year-end. Overkill is unlikely.

Banking crisis and commercial real estate debacles

Lastly, here are my views about the concerns regarding additional bank fallout and commercial real estate problems that may serve as a trigger for a possible recession.

Bank fallout risks are well contained now, compared to Silicon Valley Bank's failure in March. The Fed came up with Bank Term Funding Program ― a one-year term lending program with treasury and MBS collateralized at par value. This significantly reduces the risk of unrealized losses materializing in the case of deposit runs.

Furthermore, contagion to Systematically Important Banks is even less likely. These banks are eligible for the Fed's stress test ― which not only test loan-loss absorption ability from a 2008-like shock, but also test when inflation is prolonged and treasury yields remain elevated. Banks were proven to be resilient.

Commercial real estate is a set of structures with a different nature ― it covers retail premises, accommodation, offices and warehouses. The problem mainly lies in the office sector, as these buildings were built upon the expectation that workers will return after COVID-19 is over, which did not completely happen. Vacancy rates have risen to 19 percent as of the first quarter this year, which makes it harder for these projects to pay back bank loans.

That said it seems premature to conclude that the weakness will trigger another crisis. The delinquency ratio is rising but staying at a mere 2.8 percent as of April, according to Trepp. Owners are exerting their efforts e.g. seeking an alteration of purpose (transforming them to exhibition spaces), as well as changing the financing structure toward equity investment.

Overall, fears of a U.S. recession exist in many areas, but known risks are controllable.

The writer is the chief economist at Meritz Securities, Seoul.