I’m joining the crowd and calling it: A new NBER-defined recession will begin by March 2025. (More on that date later, but, obviously, the specific timing is a bit tongue-in-cheek.)
Throughout 2022 and much of 2023, it felt like everyone and their mommas predicted a recession for the U.S. economy. It seems like momma and her kids have taken a left-hand turn off that path and are beginning to believe the U.S. economy will absorb over five percentage points of interest rate hikes by the Federal Reserve. In short order, the conversation has shifted from “hard landing” (i.e., a recession) to “soft landing” to “no landing” (i.e., not only no recession, but no slowdown). History would contend that way of thinking is naïve. There will be a recession, and it will be tied to higher interest rate hikes.
Higher interest rate hikes affect the economy with long and variable lags. The lag effect occurs because, in part, it takes time for higher rates to grip the pocketbooks of consumers and businesses. Many months after the Federal Reserve begins raising interest rates, people and companies may suddenly feel the burden of higher debt refinancing. Or, over time, a steady grind eats away at the disposable income and margins of consumers and companies.
It is possible that the last interest rate hike by the Fed for this cycle was in July 2023. It is also possible they have one more up their sleeve for their November 1, 2023 meeting. We won’t know except in hindsight when the last Fed hike occurred. Since 1981, the historical delay between the final rate increase of a hiking cycle and the start of the next recession has been 11 months.
Having absolute knowledge about when the last Fed hike occurred is not a perfect input in determining the start of the next recession. The timing of the impact of the higher rates on the economy is variable, ranging from six months in 1981 to 17 months in 2009. Whether the last hike was in July or November of 2023, those time ranges argue that the next recession could begin anywhere from January 2024 to March 2025.
While it would be helpful to have a more precise determination of when to expect the next recession, perhaps the broader point should not go unnoticed: It is naïve to think that a recession isn’t lurking. And what does that mean for investors? It means, in general, selling stocks and buying bonds—but not necessarily yet (unless that fits into your financial plan, of course). The aggregate weight of higher costs is adding up slowly and surely. At some point, likely before March 2025, it will become a weight that crushes the U.S. economy into a contraction.
The silver lining is that a recession should be the final nail in the inflation coffin. DataTrek compiled data from the U.S. Bureau of Labor Statistics to create the chart below. Economic downturn prompts disinflation.
The typical post-recession decline of prices was about 2.0 percent over a range of about one to two years. (The COVID-19 recession of February 2020 wasn’t typical, but costs nonetheless declined rapidly.) A recession starting in mid-2024 and dragging down prices seems to script for the Fed. The Fed’s target for inflation, as measured by Core Personal Consumption Expenditures, is 2.0 percent.
The next PCE report will be released on Friday, September 29. Core PCE peaked at 5.4 percent in February 2022 and was still at 5.2 percent in September 2022. A year later, Core PCE is still stuck above 4 percent. It is expected to barely crack below the 4 percent mark this week. That is a meaningful drop from a year ago, but still well above the Fed’s target.
The Fed’s Summary of Economic Projections predicts an annual average of a 3.9 percent inflation rate in 2023, 2.6 percent for 2024, and 2.2 percent for 2025. Much of the disinflation from last year has been due to supply chain improvements. With supply chain issues mostly behind us, it may take a recession to bring inflation down to the Fed’s 2 percent target. In response to a recession, inflation would drop by about 2 percent, bringing Core PCE to about the Fed’s 2 percent target. The Fed will then move to reduce the federal funds rate from about 5.5 percent to 3 percent.
How do I calculate a projected 3 percent federal funds rate? In the long run, the 10-year Treasury note should yield roughly the sum of the long-term trend of Gross Domestic Product (about 2 percent) plus the productivity rate (about 1.5 percent). That sums to 3.5 percent. Due to risk premia and the time value of money, the federal funds rate (aka the overnight rate) should yield about 50 basis points lower than the 10-year Treasury, or about 3 percent.
Getting to the end of 2025 might be challenging for the stock market, the economy, and the consumer. But getting through 2025 sets up quite a spectacular situation for investors. But we must figure out how to get through those years without losing our shirts. Still, the stock market bulls have reasons to hold their ground for now. In fact, they have 5.6 trillion reasons.
Bank of America created the above graph, compiling Investment Company Institute data. Since the October 2022 lows for the market, more than $1 trillion has moved into money market funds. Relative to the total market capitalization of the U.S. stock market, it is not a significant amount. A case can be made for holding money market funds paying a healthy yield instead of taking the risk of equity or even bonds. However, that move to $5.6 trillion was roughly a 25 percent leap from October 2022 levels just as stocks blasted off. Despite a rising stock market, investors have pulled more than $90 billion from U.S. stock funds, some of that finding its way to money market funds.
In contrast, although the Bloomberg Aggregate Bond Index, or “the Agg,” has so far yielded a negative price return for 2023, taxable-bond funds pulled in $184 billion this year. Retail investors tend to swoosh money in the wrong direction and at the wrong time. (Let’s be honest, so do so-called professionals.) I suspect the fear of missing out on big stock gains will swoosh some of those dollars back into the stock market. That shift in sentiment will pop stock prices, perhaps just as the market tops out before a long pre-recession decline.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.