Branstad: Hi, everyone. Thank you for joining us here at Thrivent Asset Management. I'm Jeff Branstad, portfolio manager.
Lowe: And I'm Steve Lowe, Chief Investment Strategist.
Branstad: Steve, let's talk a little bit about the likelihood of a recession. We know that there's been some inversion in rates. That often signals an upcoming recession or at least an economic slowdown. There have been a lot of concerns about recessions. What's generally been driving these concerns?
Lowe: Yeah, well the risks have clearly risen fairly significantly. And that's because of inflation and more specifically because the Fed is raising rates. And Fed rate hike cycles don't end well; they usually end in recession more often than not, and rates are going into a restrictive area if the Fed raises as much as they want, meaning that they are intentionally trying to meaningfully slow the economy. And it's hard to manage that with a lot of precision.
They need to raise rates high enough to kill inflation; not only kill inflation from a demand perspective, but also a supply perspective. That should resolve itself over time in general. But this cycle is also very different than past cycles, and usually the Fed is hiking into a stronger economy, one that is growing; well, inflation rising right now, the economy is slowing down.
It's rare to see a Fed rate hike cycle into a slowing economy, which raises the risk of a recession. The reason they're hiking, it's because they need to address inflation in particular. There are already signs that the Fed is having an impact on the economy, or at least the market anticipates that.
Consumer confidence is very low. That's really more due to inflation and the impact of people's net worth going lower because the markets; shows up in less buying, less demand over time. Real wage growth is negative after inflation. And that dampens demand, too.
There are several factors working to slow the economy. You can look at the service sectors of the economy and manufacturing; there are surveys of those. Those are rolling over and will likely go to a phase where they're contracting versus expanding shortly. Business confidence is down. There are several things lining up that point toward the economy slowing.
The issue is whether or not we ultimately head into recession. As you mentioned before, the curve is inverted. And typically, that's a sign that the market doesn't necessarily expect a recession, but at least expects the economy to slow. But the curve is inverted before every recession, always. There have been times it's inverted where we haven't gone through recessions; there are false positives, but it is a sign that people are much more worried that that will happen than the market is.
Branstad: The economy is slowing. No way of avoiding that. The big question then is: how much does it slow? Does it push us into a recession? If it does, what's the severity of that recession? What's the marketplace gauging? What are the odds right now of a recession, looking at the market?
Lowe: Yeah. If you look at most models right now, it's somewhere in the 40%–60% chance. And there are some that are 100% and some that are much lower. But that seems about right, maybe 50/50. The odds increase the higher the Fed has to go and the longer it has to go. But if they have a problem pushing down inflation, then that very significantly raises the odds because the Fed is willing to sacrifice the economy a little bit or have a recession in order to dampen inflation. They have to [dampen inflation]; that's job number one, the priority for them right now. But it's not given either. The odds are significant but not given.
And if we have one, I think it's most likely to be moderate. And the economy doesn't have huge imbalances like it did before the Financial Crisis. That's a positive. Consumer spending has been generally good. It's rolling over, but consumers are in good shape. They still have savings at very, very low debt levels compared to where they were going into the Financial Crisis. Companies have strong balance sheets. Earnings are still relatively solid. We expect them to slow. When you look – we have our own internal economic index and that's definitely rising. But it's not to recessionary levels.
There's a chance that we end up in what I would call a technical recession. Usually, most people look at what's called GDP, gross domestic product, and there are some accountings for imports, exports, and inventories, which is why it was negative in the first quarter. You could see that in the second quarter happen.
There's some obscure government agency, the National Bureau of Economic Research, that declared the recession, but they look more broadly at that.
The point is that you can see headlines in the media that we're in a recession, but the gross domestic income, which is really what people make in wages and income, that's been very, very strong and it's very odd to have a recession with that strong.
Branstad: So, the market, has it already priced in this moderate recession? Or what are the risks to the market with that official declaration of "we're in a recession"?
Lowe: The market has priced in – it varies market to market, but it has priced in significant odds of a recession. It's the reason why equities fell. You've seen credit sell off. And that's somewhat where the 50% odds come. But it's still plausible for the economy to avoid a recession, a so-called soft landing.
Lowe: The last time that really happened, the Fed was raising in the 90's to dampen inflation and they managed to slow growth and slow inflation without causing a recession.
I think, as we talked about, the key point is that the underlying strength of the economy is good. what would it take for the Fed to avoid a recession? One is you need to see inflation start rolling over. In other words, you need to take the excess out of the economy without actually tipping it over. Lower rates, also.
And if they eventually start cutting rates, or long-term rates fell enough in anticipation that the economy is slowing, that would help stabilize the housing market. Lower commodities would also help.
You could paint a very plausible scenario where markets and people respond to higher rates but don't get pushed over the edge.
Branstad: Yeah. And like you said, there's enough positive things going on in the economy right now that, even if we do slip into a recession, that's why probably a lot of people are expecting a more moderate recession rather than something severe and debilitating.
Lowe: If there is a recession, the impact would be – it varies from recession to recession; there's a wide range. If you look at the impact on equities, anywhere from -15% to 60% in the past [is what] the average or median is. We got close to that. When the S&P bottomed, it was down 23–24%. The range of an average recession is somewhere around 24 to the mid 30's for the equity market. There was a lot priced in already.
The other impact that you would see is earnings supply. And typically, that's on the order of 15–20%. And I think that's embedded in pricing already. But there's a wide variation.
If we had a recession, you would see rates go down significantly. Particularly ten-year would go through 2% most likely. You're going to see credit spreads, or the compensation you get for taking risk, and high yield or investment-grade corporates go out fairly significantly. We're not there yet. Defaults would increase.
And again, all these markets have anticipated recession, so there's a fair amount priced in. Overall, I think the odds are significant, but that's not our base case.
Thanks again for joining us today. For more information, please visit us at thriventfunds.com. Goodbye, and we'll see you next time.