A little over two months ago – in early April – Deutsche Bank shocked Wall Street when it became the first bank to break with the mold of “cautious optimists” when it made a US recession its base case (agreeing with our dire assessment from late 2021 that a recession was inevitable, if disagreeing with our timeline which put the recession smack in the middle of the second half of 2022, followed by more QE). Well,, since then things have only gone from bad to worse for the US economy, with the Citi US Eco surprise index plunging to pre-covid levels and multi-year lows…
… while the Atlanta Fed GDPNow tracker for Q2 has collapsed to precisely 0.0%, implying that a technical recession is now virtually certain absent a dramatic improvement in the US economy in the remaining ten days of June, and Q2, which is very much unlikely since the slowdown in the US economy is only accelerating to the downside.
Amid this continued deterioration in US economic data, we said that the market’s jarring repricing lower was evidence that a recession had become the baseline, and we predicted that “every Wall Street bank would revise their GDP forecasts to contraction in the coming days.”
Sure enough, we were right once again because late on Sunday, Nomura became only the second bank to join DB in calling for a recession as its base case, and also became the first bank expecting this outcome to hit some time in the second half (unlike DB’s generously delayed forecast of a “late 2023” recession).
And once again echoing what we said back in December 2021, when we predicted that “the Fed is hiking rates into a recession”…
… Nomura warns that the “Fed’s commitment to restoring price stability will likely push the economy into a downturn.” I.e., Powell will hike the US right into a recession.
While there is a lot of useful data in the full note (available to premium ZH users in the usual place), we will excerpt some of the key highlights below:
- With rapidly slowing growth momentum and a Fed committed to restoring price stability, Nomura believes a mild recession starting in Q4 2022 is now more likely than not (ZH: expect the mood to deteriorate further as “mild” eventually becomes “jarring”).
- Financial conditions are likely to tighten further, consumers are experiencing a significant negative sentiment shock, energy and food supply disruptions have worsened and the outlook for foreign growth has deteriorated. All these factors will likely contribute to the expected downturn.
- Relative to previous downturns, Nomura believes that the significant strength of consumer balance sheets and excess savings should mitigate the speed of the initial contraction. However, policymakers’ hands are tied by persistently high inflation, limiting any initial support from monetary or fiscal stimulus.
- The bank lowered its real GDP growth forecast in 2022 to 1.8% y-o-y (-0.3% Q4/Q4), down from 2.5% (1.4% Q4/Q4). In 2023, it expects real GDP to decline 1.0% y-o-y (-1.2% Q4/Q4), down from +1.3% (+0.6% Q4/Q4).
- The bank also expects the unemployment rate to rise to 5.2% by end-2023 and 5.9% by end- 2024, above previous expectation of a rise to 4.3% over that period.
- For inflation, the near-term impact of the bank’s economic outlook revision is more muted considering the persistent nature of rent inflation and rising inflation expectations. Nomura only lowered its Q4/Q4 2022 core PCE inflation forecast 0.1% to 4.4%, largely reflecting core goods prices. However, the Q4/Q4 2023 core PCE inflation forecast now stands at 2.4%, down from 2.8% previously.
- With monthly inflation through 2022 likely to remain elevated, Nomura economists believe the Fed response to the downturn will initially be muted, and expect ongoing rate hikes to continue into 2023, but with a slightly lower terminal rate of 3.50-3.75% reached in February (down from our previous forecast of 3.75-4.00% in March). However, it now expects rate cuts in H2 2023, lowering the funds rate to 2.875% by end-2023 and 0.875% by end-2024.
Nomura then goes into a detailed review of all the various factor that have made a late-2022 recession inevitable. We excerpt from these below:
- The persistence of inflation and a single-mandate Fed – From a very high level, the ongoing persistence of elevated inflation and growing evidence of unanchored inflation expectations are the two key drivers of our expected growth downturn. Despite the Fed’s significant hawkish pivot since November 2021, inflationary pressures have not eased meaningfully and may have arguably worsened (Fig. 2 ). Inflation expectations are showing growing signs of being unanchored (Fig. 3 ). Against that backdrop, we believe the Fed’s efforts to realign demand with depressed supply to rein in price pressures will ultimately drive the economy into a mild recession.
- Recent financial conditions developments and their implications for growth – Financial conditions have tightened considerably in 2022, but not yet to levels that would suggest a significant drag on growth. Broad measures of equity prices have declined between 20-30% and BBB option-adjusted corporate credit spreads have widened over 60bp. While NFIB’s latest data suggest small businesses are not yet experiencing a material deterioration in credit conditions, that could soon change. Altogether, our financial conditions index has moved lower – implying a roughly neutral impulse to growth after hovering around 3pp in late 2021 – but has not yet entered negative territory (Fig. 4 ).
- Interest-rate sensitive GDP components – Within the real economy, interest-rate sensitive GDP components are likely to accelerate the downturn. Already, housing demand has shown signs of pronounced weakness as both existing and new home sales move lower and starts and permits lose steam. The sensitivity of US GDP growth to higher interest rates could be larger in this cycle, considering interest rate-sensitive components comprise a historically elevated share of real GDP (fig 5).
- Durable goods consumption jumped sharply above its recent trend during the pandemic, due to constrained service activity and significant policy support. With rapidly rising interest rates, and deteriorating economic conditions, the pullback in durable goods spending in 2022 and 2023 will likely result in a larger-than-usual negative impulse to growth. In particular, to some degree, durable goods consumption and home sales are interconnected and the recent deterioration in home affordability could weigh on durable goods consumption significantly (Fig. 6 ).
- Rapid home price growth during the pandemic has pushed up the home price-to-rent ratio to levels not seen since the early 2000s (Fig. 7 ). Despite the lag with which home prices will likely respond to the downturn, we see elevated risk of price corrections, which could prolong the downturn. Moreover, if workers lose bargaining power for remote work opportunities as the unemployment rate rises, COVID-related migration could reverse, which may exert downward pressure on home prices in areas that benefitted from the shift in work conditions
- Consumers are experiencing a sentiment shock – For much of 2022, we have expected strong service consumption – due to re-opening, pent-up demand and excess savings – to support overall consumer spending despite headwinds for goods consumption. However, in recent months, meaningful signs of a negative consumer sentiment shock have emerged. Google search activity for “recession” has increased above levels that prevailed during the Global Financial Crisis (GFC) and the University of Michigan’s consumer sentiment index dropped to its lowest level on record in June (Fig. 8 and Fig. 9 ).
- In May, real core retail sales declined notably, but real food services spending also faltered, suggesting a growing risk the expected rotation to services to offset weakness in goods may already be unraveling. The Fed intends to materially slow demand to rein in inflation, and continued elevated employment growth in that context seems increasingly unlikely. Indeed, as evidenced by the June Summary of Economic Projections (SEP), the Fed’s efforts are increasingly designed to push up the unemployment rate over the forecast horizon to lower inflation by reducing labor market tightness.
- Commodity price shocks risk becoming the new normal – In addition to tighter financial conditions, the exposure of interest-rate sensitive sectors and a consumer sentiment shock, the outlook for supply shocks – particularly for energy and food – has continued to deteriorate this year. The ongoing Russia-Ukraine war and its impact on global commodity markets and supply chains has shown few signs of improvement, and may have started to become more entrenched. After commencing 2022 around $75/barrel and spiking to as high as $123/barrel at the onset of the war, WTI crude oil prices have remained persistently high, averaging close to $120/barrel during June. Retail gasoline prices in the US have risen sharply and persistently from around $3.30/gallon at end-2021 to over $5.00/gallon in June. Increased demand from the ongoing reopening of China after Omicron-linked lockdowns suggests further upside risk to energy prices.
A challenge to bears is that while a recession is now assured, the Fed’s intervention to contain it will be delayed: here we agree with Nomura that “one of the most significant differences between our expectation for this recession and prior episodes involves the response from policymakers. In the current high-inflation environment, both monetary and fiscal policy are likely to be much more restrained in their response relative to previous recessions.” That is until everything comes crashing down in a global, synchronized recession. Here are some more details from Nomura:
The Fed’s hands are likely to be tied through 2022 by elevated inflation – Fed officials have been clear they will prioritize restoring price stability above all else. Unfortunately, we believe monthly core inflation is likely to remain quite elevated and above levels with which the Fed would be comfortable, at least through 2022, and likely into early 2023. As shown in Fig. 2 , the main driver of elevated trend inflation pressures continues to be owners’ equivalent rent (OER) inflation – one of the largest, and “stickiest,” inflation components. Due to BLS methodological differences and the lead-lag relationship with shelter prices and the economic cycle, Nomura does not expect OER inflation to meaningfully improve until early 2023. As a result, the Fed is likely to downshift to a 50bp rate hike in September, and 25bp per meeting thereafter before holding rates at an elevated rate. However, we do not expect any signs of potential easing from the FOMC, i.e., rate cuts or QE, in the near term.
Over the past decade and a half, the proximity of the Fed’s policy rate to the effective lower bound (ELB) has helped establish a standard “playbook” for responding to recessions, exemplified during the COVID crisis: cut rates swiftly and sharply to the ELB and prepare for large scale asset purchases (LSAPs, or QE), in order to provide additional accommodation.
However, Nomura believes that this playbook is likely to be of little use to policymakers in the current environment, due to persistently elevated inflation. We disagree: while Nomura expects rate cuts to start in H2 2023, they will likely come much later than they otherwise would have absent strong inflationary pressures, we believe that once the US is hit with the deflationary tsunami that is coming, prices will collapse much faster than most expect. Nomura fails to accept this and instead it predicts a pace of rate cuts which will likely to be slower than in previous recessions (Fig. 16 ), adding that “the Fed will continue to reduce the size of its balance sheet into 2023 considering its historically elevated size and their plans to tighten financial conditions beyond raising short-term rates. Both actions run against what policymakers would likely prefer to do in a standard recession.” Again, we disagree and expect a full-blown QE episode to be unveiled as soon as early 2023.
Where we do agree with Nomura is in the bank’s assessment that “fiscal policy support is likely to be absent, or outright restrictive”:
Similar to monetary policy, we believe fiscal policy will largely remain on the sidelines for the expected recession, aside from the regular impact of automatic stabilizers like unemployment insurance. Policymakers in Washington across the spectrum have increasingly taken the view that significant, and unprecedented, fiscal support during the pandemic helped exacerbate inflationary pressures. That experience, combined with widespread voter dissatisfaction due to inflation, will make many members of Congress reluctant to provide any kind of discretionary fiscal stimulus. One of the most striking indications of just how quickly the conversation in Washington has changed has been recent commentary from Biden administration officials on the potential for deficit reduction to help combat inflation. Treasury Secretary Yellen in particular has suggested deficit reduction could help address elevated inflation pressures.
Furthermore, as we have frequently noted…
… Nomura is certainly correct in predicting Congessional gridlock: “with our expectation of a return to divided government after the November 2022 midterm elections – we believe Republicans are likely to take back both the House and the Senate – Washington will likely return to gridlock. Republicans face few incentives to collaborate with the Biden administration with an important presidential election looming in 2024. Moreover, Republicans may be emboldened during debt limit and regular appropriations debates to push for outright spending cuts, which could exacerbate the recession in 2023.”
Here, we would predict that far from making monetary policy less likely, the fact that no fiscal stimulus is coming until at least 2025, means that the Fed’s liquidity firehose will be front and center as soon as late 2022/early 2023.
Putting it all together
Nomura expects a “modest” recession to start in Q4 2022, Combining the factors above; relative to previous downturns, the bank expects a shallower and longer path, for three reasons.
- First, robust consumer balance sheets and excess savings should limit how quickly growth decelerates.
- Second, the lack of policy support – monetary and fiscal – at the onset of the recession will likely prolong its length.
- Third, despite some concerns over corporate debt, there is no obvious financial accelerator to amplify the recession shocks like the GFC (Fig. 18 ).
In terms of annual changes, Nomura lowered its real GDP growth forecast in 2022 to 1.8% yo-y (-0.3% Q4/Q4), down from 2.5% (1.4% Q4/Q4). In 2023, we expect real GDP to decline 1.0% y-o-y (-1.2% Q4/Q4), down from +1.3% (+0.6% Q4/Q4).
In terms of unemployment, Nomura expects nonfarm payroll employment growth to begin decelerating, but not as quickly as overall growth. Labor demand remains elevated and some firms may engage in labor hording during the initial stages of the downturn, resulting in weak productivity growth. NFP is likely to start declining in February 2023 under our base case. The unemployment rate will likely rise from an expected trough of 3.3% in the next few months to 3.5% by end-2022, 5.2% by end-2023 and 5.9% by end-2024. Our unemployment rate trajectory is less severe relative to the GFC, but slightly higher than 2001, reflecting less initial policy support (Fig. 19 ).
Finally, when looking at its update inflation outlook, Nomura writes that it expects Inflationary pressures remain strong and, due to a number of reasons, and thinks that the economic downturn may not exert substantial near-term disinflationary shocks, resulting in only modest revisions to its inflation forecast.
First, supply constrains will likely continue to help prices remain at elevated levels. To be sure, there have been some encouraging signs of inflationary imbalances easing in certain goods prices, such as home appliances and furniture, which motivates Nomura to lower its forecast for core goods prices modestly. However, vehicle prices, determined by complex supply chains, continued to increase, and it will take time to meet accumulated pent-up demand for vehicles, even if auto production picks up. As a result, Nomura expects core goods prices to continue to make a positive contribution to core PCE inflation on a y-o-y basis until mid-2023 (Fig. 20 ).
- Second, the Japanese bank expects inflation to be driven more by service prices, which are “stickier” than goods prices. In particular, rent and owners’ equivalent rent (OER) have been accelerating in recent months and private data on rent and house prices suggest BLS rent inflation and OER will likely continue to firm for the next few quarters (Fig. 21 ). Considering rent and OER are cyclical components, rent-related components will eventually decelerate in reaction to a recession. However, rent/OER tends to lag the broader economic trend as rent for existing leases only updates every one or two years and economic uncertainty could increase the flow of prospective home buyers towards renting. Historically, the impact of recessions on monthly changes in trend inflation measures becomes more pronounced only 6-12 months after a recession begins (Fig. 22 ).
- Third, long-term inflation expectations might have started to de-anchor as Nomura expects the Fed’s CIE index to jump in Q2 2022 (see Fig. 3 ). If households and businesses continue to raise their inflation expectations, the risk of an emergence of a new, high-inflation regime would increase, suggesting high inflation could become more persistent despite a recession (forcing the Fed to raise its inflation target to 3% of more). Considering the formation of inflation expectations by households is sensitive to commodity prices, such as food and gasoline, higher commodity prices could enhance the persistency of inflation. Altogether, Nomura lowered its core PCE inflation forecast in Q4 2022 and 2023 only modestly by 0.1pp to 4.4% and 0.4pp to 2.4%, respectively. On a m-o-m basis, Nomura expects core PCE inflation to move below 0.17% (annualized 2%) in Q3 2023, which is consistent with our expected timing of the Fed starting rate cuts.
Of course, Nomura is just the first of many and now that the seal has been breached, we expect many more banks to not only make a recession their base case but to set the timing squarely into second half 2022 territory. What happens next, and predicting (correctly) how – and when – the Fed reacts to this recession will make some people very, very rich in the coming months.