Inflation is Slowing and We've Avoided a Recession. Summer is Going to Be a Stunner for Stocks.

Over the past two years, economic pessimists, often referred to as hard-landers, have presented numerous theories and charts predicting that higher interest rates would inevitably push the U.S. economy into a recession. Currently, these hard-landers insist that their recession forecasts will soon be validated, with some even arguing that a recession is already underway.

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Contrary to these predictions, the U.S. economy has continued to grow, and the labor market remains strong. The S&P 500 and Nasdaq are at record highs, despite the Federal Open Market Committee (FOMC) signaling only one possible cut in the federal-funds rate this year.

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At the beginning of the year, markets expected up to seven rate cuts. Hard-landers initially argued that the Federal Reserve would need to induce a recession to control inflation through tightened monetary policy. However, as inflation proved more transitory, they shifted their stance, suggesting that the Fed would need to ease policy aggressively to avoid a recession.

A common factor in the hard-landers' gloomy forecasts is their reliance on Technical Analysis of Macroeconomic Data (TAMED). Historical causal effects and correlations during past Fed tightening cycles suggested an imminent recession. While these observations were accurate in noting that previous tightening cycles often led to financial crises and subsequent recessions, the post-pandemic economic landscape is vastly different, making past indicators less reliable.

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One key misstep in the TAMED approach is the distinction between leading and coincident economic indicators. The Conference Board’s Leading Economic Index (LEI) has dropped significantly since its peak in December 2021, falling over 14% by May of this year. In contrast, the Index of Coincident Economic Indicators (CEI) has steadily climbed, reaching new record highs since July 2021, despite the LEI’s downbeat forecasts. The CEI's rise correlates closely with S&P 500 forward earnings, which also hit record highs, nearing the year-end target of $270 per share.

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The LEI's continued decline is partly due to its heavy reliance on manufacturing and construction components, which are less reflective of the current U.S. economy that is now more service and technology-oriented. Employment in manufacturing, mining, and construction has significantly decreased, now comprising just 10% of total payrolls compared to one-third in the early 1950s.

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Moreover, many hard-landers overlooked the impact of a property-led recession in China, which contributed to lowering inflation in the U.S. The core goods consumer price index fell 1.7% year-over-year in May, aided by a 2% drop in import prices from China.

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The inverted yield curve, a historically reliable recession predictor, has also become less effective. The 2-year U.S. Treasury yield has been above the 10-year Treasury yield since November 2022 without triggering a recession. While the yield curve typically inverted as the Fed raised short-term rates to combat inflation, investors would buy long-term bonds anticipating a future rate cut. This time, the Fed quickly contained a regional-banking crisis in March 2023, allowing investors to continue earning attractive returns on long-term bonds.

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Looking forward, we expect the 10-year Treasury yield to remain between 4% and 5% for the rest of the year, with inflation moderating toward the Fed’s 2% target. The yield curve is unlikely to normalize without significant rate cuts from the Fed.

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The Sahm Rule, a newer recession indicator, suggests a recession when the three-month average unemployment rate rises 0.5 percentage points above its low in the past 12 months. As of May, this measure was at 0.4 points. However, we believe that simple moving averages are insufficient for economic forecasts without considering the unique factors of each cycle. For example, the unemployment rate increase in May was largely due to younger, often still in college, workers.

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The Sahm Rule and TAMED indicators also fail to account for structural shifts in the economy, such as the demographic changes post-pandemic. Many baby boomers retired early, creating job openings for younger workers. With baby boomers holding a significant portion of household wealth, their spending has boosted consumption, particularly in healthcare, leisure, and hospitality sectors.

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In conclusion, while economists may continue to seek straightforward rules to predict recessions, a nuanced analysis of economic details suggests that inflation will moderate, the economy will grow, and the "Roaring 2020s" are still in effect.

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