On Wall Street, there are many common sayings, but one that rings true time and time again is "The Fed raises rates until something breaks." With the recent banking turmoil experienced last month, people are questioning if the collapse of Silicon Valley Bank in the US and Credit Suisse in Europe is the breaking point that will cause the Fed to stop its tightening policy. Analysts are predicting that a pause in rate hikes by the Fed will be followed by rate cuts before the end of the year. However, the more pressing question is whether these measures will be sufficient to address the economic damage caused by the most aggressive tightening cycle by the Fed in half a century.
It is widely acknowledged that the Federal Reserve's monetary policy has a long and variable lag, which means that it takes time for the economy to adjust to rising or falling interest rates. Despite the hundreds of PhD economists at the Fed, their ability to accurately time their rate hikes and cuts is no more scientific than gauging wind direction by sticking a finger in the air. The Fed determines when to stop raising rates by observing when the economy stops growing, and when to stop cutting rates by observing when the economy stops declining. This means that the Fed is constantly looking backward and reacting to past economic conditions instead of being proactive. They fail to recognize that it takes at least a year for their policy moves to be fully absorbed by the economy. Consequently, like the captain of the Titanic, the Fed often realizes too late that a recession is looming, and by the time they try to steer the economy away from disaster, it is already too late. The economy’s fate is sealed by the lag of monetary policy, and we need to brace for the coming impact.
For the past six months, we have been anticipating an impending recession, but some are now questioning whether we will avoid it altogether as the economy appears to be moving along. However, by examining the Institute for Supply Management's Purchasing Managers Index (PMI) which gauges manufacturing activity, we can see a deceleration in the US economy since Spring 2021, as the growth rate has been slowing down. The PMI indicates economic growth when it is reading above 50 and contraction when below it. We experienced our first contractionary reading in November 2022, and have continued to fall deeper into contractionary territory ever since. In March, the PMI was at 46.3, which is the median level associated with recessions since the 1950s. Additionally, the Conference Board's Leading Economic Index (LEI), which is composed of 10 indicators that lead the economy’s growth rate, typically ranges from -1.6 to -2.6 at the start of a recession. However, the latest reading for February was -6.5, with only the 2001 recession displaying a more negative number at the beginning of a recession. Further, the Conference Board’s Coincident Index, which is composed of indicators that move with the economy’s growth trends rather than lead them, typically displays a growth rate between 2.3%-2.4% as a recession begins and for February came in at 1.4%. To summarize the data in the following table, three different economic measures are currently at or below the average levels at the onset of a recession and argues we may be closer to a recession than many believe.
Despite the most recent readings for the PMI and Conference Board's LEI suggesting that we should already be in a recession, job growth remains robust, and consumers are continuing to spend on services, which is keeping the economy moving forward. This poses the question of whether the call for a recession is still early or, as some believe, will never materialize at all (the so called ‘no landing’ scenario). Answering this question is crucial since it will determine whether we should maintain our defensive position in anticipation of a potential recession or begin deploying cash if a recession is avoided, indicating that the stock market's lows are behind us. If the recession call remains valid, why has our progression towards recession taken so long? There are a couple trillion reasons for this.
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While the U.S. consumer was locked up in their homes many continued earning wages and, in addition, we had trillions in government stimulus checks that found their way into consumer banking accounts. Given the lack of spending for over a year, the U.S. consumer accumulated over $2 trillion in excess savings and it has been the drawing down of this excess savings that has continued to power the economy along even while the manufacturing side of the economy has been in recession for nearly half a year as the following article highlights.
U.S. consumers have spent more than $1 trillion saved up during the pandemic
U.S. consumers have made a healthy dent in savings stockpiles accumulated during the pandemic.
And this drawdown presents a challenge for the economy in 2023.
New data from JPMorgan Asset Management published Monday shows estimated "excess savings" from U.S. households now stand at $900 billion, down from a peak of $2.1 trillion in early 2021 and roughly $1.9 trillion at the beginning of last year…
Households saved more than 10% of their income in each month between March 2020 and May 2021, building a multi-trillion-dollar stockpile of savings to run down in the future.
And that future is now.
As has been chronicled over the past two years, these accumulated savings for consumers have powered robust spending, even in the face of 40-year highs in inflation and a softening labor market.
But with no new stimulus programs imminent and the economy showing some signs of feeling the impact of the Federal Reserve's aggressive rate hikes, the ability for U.S. consumers to power unexpected growth will likely come to an end…
In a piece previewing the U.S. economic outlook for 2023 last month, Ian Shepherdson at Pantheon Macroeconomics wrote: "The only reason for hesitating before forecasting a recession is that the private sector is still sitting on some substantial excess cash accumulated during the pandemic."
In Shepherdson's view, it is likely the bottom 40% of earners have run down all excess savings accumulated during the pandemic. This suggests the pace at which consumers spend down their remaining stockpiles will slow, as those on the higher end of the income distribution have more scope to hold off drawing on savings to meet current obligations.
The drawdown of trillions in excess savings has helped shield the consumer from a 40-year high in inflation as well as from a softening labor market. We believe this cushion has only delayed the inevitable recession rather than avoid it and see the odds of a recession in the coming months as highly probable. We simply do not see any major stimulant to jump start the economy, in fact just the opposite. Since the collapse of the 2nd and 3rd largest bank failures in US history last month with Silicon Valley Bank (SVB) on the West Coast and Signature Bank on the East Coast, banks have tightened the reins on lending even further amidst increasing uncertainty about the outlook and a continual outflow of deposits. In the last two weeks of March, commercial banks experienced their largest recorded contraction in total loans and leases outstanding since the 1970s. This contraction is even more severe than what we observed during the 2007-2009 financial crisis, which was the most significant financial crisis since the Great Depression.
According to one of our Financial Sense Newshour regulars, Jim Bianco of Bianco Research, we are currently experiencing a "bank walk" instead of a widespread bank run. Consumers are withdrawing their deposits from not only smaller commercial banks but also larger ones. Over the past year, large commercial banks have lost nearly $750 billion in consumer deposits. This trend has been ongoing for over a year and did not start with the collapse of SVB. Until last month, small commercial banks were holding onto their deposit base, but they lost almost $250 billion in deposits over the course of two weeks. Therefore, large and small commercial banks have lost nearly $1 trillion in deposits, which directly affects their ability to lend, resulting in the decline in loans and leases outstanding as shown above.
The tightening of lending standards by banks, even before the collapse of SVB, is making it difficult for consumers and businesses to borrow, resulting in a decline in loans outstanding. The NFIB Small Business lobby surveys small businesses each month and for March the question asking the availability of credit to small businesses plummeted 4 points. That doesn’t sound like much, but it was the largest monthly decline in 20 years. Further, when asked if now was a “good time to expand,” the results came in at only 2%. This matched the March 2009 low, and only 1980 was worse. Think about that for a second, small businesses feel now is a worse time to expand than even when every small business in U.S. was locked down in April of 2020.
This decline in access to credit and deep pessimism about expanding for the future will likely lead to a recession. Although we do not yet have the first quarter senior loan officer survey by the Federal Reserve, we anticipate that already tight lending conditions will become even tighter, further constraining the flow of credit into the economy. This could lead to a contraction in corporate capital expenditures, a retrenchment by the consumer, and an increase in loan-loss reserves by banks, preparing for the coming wave of defaults. These are signs of battening down the economic hatches, which are typically seen before the economy slips into a recession. Currently, there is no clear stimulus being applied to the economy to turn things around, which is why we are keeping client accounts near maximum defensive positions. We simply see far more downside risk than upside at this point and believe defense remains the most prudent course of action.
Considering that the onset of the recession has been more protracted than anticipated, the downturn could potentially unfold at a gradual pace. As such, it remains uncertain when the economy will hit its lowest point. To determine this, we will depend on leading economic indicators and financial market signals for guidance. We will also be looking to redeploy cash into selective areas that provide attractive value and growth potential. The ongoing race in artificial intelligence along with a continuing shift towards electric vehicles will continue to spur greater production of semiconductor chips. This is why we have semiconductor companies on our radar as well as some select industrial companies that would stand to benefit from China emerging from its lockdowns. There are other pockets of value we will be monitoring and will alert clients through our writing when we feel it is time to wade back into the water, but that time is not now. If you have any questions, please do not hesitate to reach out to your wealth manager.
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